• The weekly insight is a teaser into the opportunities – and pitfalls! – in the Asian capital jungles.
• Get The Moat Report Asia – a monthly in-depth presentation report of around 30-40 pages covering the business model of the company, why it has a wide moat and why the moat may continue to widen, a special section on “Inside the Leader’s Mind” to understand their thinking process in building up the business, the context – why now (certain corporate or industry events or groundbreaking news), valuations (why it can compound 2-3x in the next 5 years), potential risks and how it is part of the systematic process in the Bamboo Innovator Index of 200+ companies out of 15,000+ in the Asia ex-Japan universe.
• Our paid Members from North America, Europe, the Oceania and Asia include professional value investors with over $20 billion in asset under management in equities, some of the world’s biggest secretive global hedge fund giants, and savvy private individual investors who are lifelong learners in the art of value investing.

Can You Guess This Asian Wide-Moat Company?

Grow Market Share of Ice Cream from 2% to 78% in Asia? You Need A “Passion to Serve”

How do you grow a consumer brand product in Asia from 2% market share in 1990 to a dominant market leadership of 78% today? And not just once off, but multiple times in different consumer product categories?

It’s all about “a passion to serve”, the down-to-earth third generation business leader and CEO Mr. C said. We are impressed by Mr. C who has steered the family business, established in 1958, through challenging times during the 1997/98 Asian Financial Crisis from an unfocused, debt-fueled conglomerate that was involved in F&B, property, banking and semiconductor to bringing greater focus on its core consumer brand products business to command market leadership in aspirational and lifestyle consumer brand products.

This month, we highlight an Asian wide-moat innovator who is the #1 ice-cream and pasta maker in its home country with a market share of 78% and 40% respectively. [Company’s name] has also leveraged upon the ice cream brand to create an innovative RTD (ready-to-drink) milk brand products, including building the chocolate-flavoured milk to become #2 behind Nestle. [Company’s name] is also the main supplier of bun requirement to McDonald’s and its high speed bun production business has expanded to serve other quick-serve restaurants (QSR) customers that include Wendy’s and KFC.

Mr. C has cultivated a unique entrepreneurial ability and impressive track record to acquire or build small heritage brands in different food and beverage categories and transform them into market leaders.

• The ice cream business was acquired from a family in 1990. Under the previous owners, the ice cream brand was fading out brand for middle-aged ice cream consumers with a mere 2% market share. [Company’s name] contributed financial resources, marketing savviness, and distribution network. The result was disastrous for then market leader which was caught unprepared. [Company’s name] captured market leadership with a dominant share of 78%. The per capita ice cream consumption in this Asian country in 2009 was estimated at 0.95-1 liter, which is one of the lowest in Asia. Thus, there is huge potential for the domestic ice cream market to double when [Company’s name] further penetrates both the modern and traditional trade channels.

• The pasta brand was developed internally and has a market share of 1% when [Company’s name] entered the business in 2001. In 2008, [Company’s name] invested in a new pasta plant, which is supposedly Asia’s largest and most modern pasta plant. The pasta brand targeted mass market appeal by pioneering in 2010 value-for-money product bundling. We are impressed by how the pasta business has effectively brand themselves in the ad campaigns for mothers who need to satisfy hunger, express love, be recognized and prepare the best food for their family and loved ones, creating a unique consumer mindshare and psychological moat to become the #1 leader, relegating the pasta brand of a global MNC to #2. [Company’s name] went on to acquire the #2 pasta brand from the MNC in 2014 to further consolidate the market and augment its offerings, strengthening its potential for market dominance to achieve resilient steady growth.

How did this “passion to serve” arose?

Mr. C explained: “Let me share the story of our family and the story of [Company’s name], which is about the passion to serve. As a young boy, I grew up in our old house in ‘P City’. ‘P City’ during that time was known for its fires and floods so our house was usually a site for relief operations — something that my father loves to do since he has had this passion to serve ever since. He was also one of the leaders for good government in ‘P City’. So growing up, I was exposed to serving others or doing something good. Of course, as a young kid, I was also a fan of Batman, and most toys given to me were all his gadgets. In a way, I realize now that subtly, I was influenced by this superhero, whose passion was to fight evil and serve the people in Gotham City. I guess these influences in our lives come in many ways. It just reminds me how this passion to serve has been instilled in our family and companies’ values in later years. [Company’s name] has turned 57 years old in the industry. It was not an easy ride but hard work, innovation and the passion to serve kept us going. My message to our employees is simple: God has given us our purpose in life as a company, which is to produce quality food, always at the most reasonable prices. We have survived for over 50 years because we have fulfilled this mission, and we will continue to survive another 50 years if we continue to fulfill it.”

[Company’s name] is the unsexy, simple and understandable Buffett-type of consumer business but you know what you are getting as an investor. Despite its conservative capital structure while most of its peers are relatively highly leveraged, [Company’s name] is able to achieve a decent 9.3% ROE generated from its strong brand equity. The firm’s net profit margin of 7.6% is also one of the highest in the industry, illustrating the power of its dominant market leadership in its core products. Yet, [Company’s name] trades at the relatively cheap and attractive valuations of Price/Book 1.5x, PE15e 12.3x, EV/EBIT 15x and EV/EBITDA 11x. We think that with the business reorganization to focus on the core consumer business, the under-appreciation of the synergies in the pasta business following the 2014 acquisition of the #2 pasta brand from the global MNC, and the potential doubling in ice cream per capita consumption to catch up with its Asian peers, sales and profit momentum will accelerate and market cap could double from current level in the next 4-5 years.

Who is Mr. C and this wide-moat Bamboo Innovator?

Warm regards,

KB

The Moat Report Asia

www.moatreport.com

A new monthly issue of The Moat Report Asia is now available!

Access the in-depth idea presentation:

http://www.moatreport.com/members/

• The weekly insight is a teaser into the opportunities – and pitfalls! – in the Asian capital jungles.
• Get The Moat Report Asia – a monthly in-depth presentation report of around 30-40 pages covering the business model of the company, why it has a wide moat and why the moat may continue to widen, a special section on “Inside the Leader’s Mind” to understand their thinking process in building up the business, the context – why now (certain corporate or industry events or groundbreaking news), valuations (why it can compound 2-3x in the next 5 years), potential risks and how it is part of the systematic process in the Bamboo Innovator Index of 200+ companies out of 15,000+ in the Asia ex-Japan universe.
• Our paid Members from North America, Europe, the Oceania and Asia include professional value investors with over $20 billion in asset under management in equities, some of the world’s biggest secretive global hedge fund giants, and savvy private individual investors who are lifelong learners in the art of value investing.

Warren Buffett: “Back in the mid-1990s I looked to the shoe business in Dexter, Maine, and paid $400 million for something that was destined to go to $0 in a few years. I didn’t figure that out. I paid for some transactions in BRK stock – maybe the only instance in which I felt good about the share price going down. I would say almost any time we’ve issued shares, it’s been a mistake, wouldn’t you say, Charlie?”

Charlie Munger: “Of course.”

“What I had assessed as durable competitive advantage vanished within a few years. By using Berkshire stock, I compounded this error hugely. That move made the cost to Berkshire shareholders not $400 million, but rather $3.5 billion. In essence, I gave away 1.6 percent of a wonderful business — one now valued at $220 billion — to buy a worthless business. To date, Dexter is the worst deal that I’ve made. But I’ll make more mistakes in the future – you can bet on that. A line from Bobby Bare’s country song explains what too often happens with acquisitions: ‘I’ve never gone to bed with an ugly woman, but I’ve sure woke up with a few.'”

– Buffett in 2008

Is it possible for an Asian billionaire to work alongside employees in a retail shop during weekends?

We know Sam Walton does. Even when Sam Walton was a billionaire, he still “show up regularly in the truck drivers’ break room at 4a.m. with a bunch of doughnuts and just sit there for a couple of hours talking to them.” Sam Walton would grill them: ‘What are you seeing at the stores?’ ‘How do the people act there?’ ‘Is it getting better?’ Former Wal-Mart CEO Lee Scott commented, “It makes sense. The drivers see more stores every week than anybody else in this company. And I think what Sam likes about them is that they’re not like a lot of managers. They don’t care who you are. They’ll tell you what they really think.”

Can an Asian billionaire put down his stature, face, pride and comfort to be as driven and humble as Sam Walton? Knowledge of the cognitive psychological underpinnings of the Asian entrepreneurs with Sam Walton-like psyche and the sustainability of the wide-moat businesses they built will enable the value investor to make right the investment process underlying what Buffett describes as the worst investment decision he has ever made in his entire life – his purchase of Dexter Shoes in 1993.

Before we reveal the Sam Walton-like Asian shoe billionaire whose business has compounded by nearly 10-fold in market value since 2000 to $4.5 billion, beating the domestic index which is up 35% over the same period, generating a 12th straight record high profits from over 900 stores (180 are overseas), let us revisit Buffett’s investment decision in Dexter Shoes.

At the time, Buffett’s investment in Dexter in 1993 made a lot of sense.

First, Dexter Shoes is the type of boring, unsexy businesses like See’s Candies and Dairy Queen that Buffett had invested in numerous times before to generate compounding returns for Berkshire. Unsexy but you know what you are getting as an investor. When asked why he bought Dexter at that time, Buffett commented, “Dexter Shoe is exactly the type of business Berkshire Hathaway admires. It has a long, profitable history, enduring franchise and superb management. Dexter will continue to operate as it has in the past under its existing management.”

Second, Buffett had earlier acquired in 1991 two shoe businesses – worker boat manufacturer HH Brown and women’s and nurse’s shoes Lowell – that turned out to good investments. The management at HH Brown also endorsed Dexter’s owner-managers Harold Alfond and Harold nephew Peter Lunder, giving Buffett the confidence to proclaim, “Dexter, I can assure you, needs no fixing: It is one of the best-managed companies Charlie and I have seen in our business lifetimes”. Buffett expected in 1994 that Buffett’s shoe operations to have more than $550m in sales with pre-tax earnings topping $85m. Buffett commented then, “Five years ago we had no thought of getting into shoes.  Now we have 7,200 employees in that industry, and I sing ‘There’s No Business Like Shoe Business’ as I drive to work.”

Third, Dexter seemed to have built a moat and branding price premium advantage to withstand the onslaught of cheap Asian imports – despite the higher cost of producing over 7.5m pairs of shoes annually, including 15% of US output in golf shoes, mostly onshore in Maine. Dexter’s facilities were impressive in its production efficiencies with conveyor automation. In addition, Dexter had been a business innovator by pioneering three retail trends. Firstly, Alfond is credited with the invention of the factory outlet store in selling factory-damaged (FD) shoes in the 1960s. Harold cut out the middle man and sold FDs right from a store at the back of the factory. It was an instant success. Secondly, when factories were not making enough mistakes to supply FDs, Harold pioneered the next trend in the 70s of selling stale inventory, mostly quality shoes from previous seasons. Dexter factory outlet stores started to flourish with one store after the other in eastern United States. Other shoe retailers caught on and opened their stores next to Dexter. Harold pioneered the third trend of opening entire outlet malls along busy highways and lease retail space to dozens of competitor brands. At this time in the early 90s, Dexter employed close to 4,000 people and was generating $250m in sales with retail-manufacturing earnings and steady rental services income. Buffett came knocking on the door and Harold agreed to sell out for $443m, requesting Berkshire shares instead of cash. The value of Dexter business amounted to 1.6% of Berkshire shares which was selling for around $16,000 per share.

So what went wrong? The most cited explanation was that as much cheaper shoes manufactured overseas continue to flood the American market, Dexter lost its competitiveness. Starting from 1998, Dexter started to cut jobs, citing global competition. In 1999, Dexter began to close down its manufacturing facilities. By 2000, Buffett said, “our attempt to keep the bulk of our production to domestic factories has cost up dearly.” Due to operating losses at Dexter, Berkshire wrote off $219m of Dexter goodwill. A week after the 9/11 terrorist attack, Dexter announced it was closing its final manufacturing facility in Maine, the on located in its namesake town of Dexter. In the 1960s and 70s, the shoe industry employed roughly 30,000 people in Maine. By the time Dexter Shoe shut its doors in 2001, that employment figure had dropped to 3,300, according to the Maine Center for Workforce Research & Information. Today, that figure is below 1,300.

In a little-cited and forgotten quote that goes beyond the usual heuristic checklist measure of “long profitable history” to discuss about business dynamics, Buffett explained the most important reason to understand both the mistake and the Asian shoe billionaire who worked alongside his employees in the shop during weekends, as well as to identify potential future opportunities in retail innovators. Buffett admitted, “Shoes are a tough business.. most manufacturers in the industry do poorly. The wide range of styles and sizes that producers offer causes inventories to be heavy; substantial capital is also tied up in receivables.”

Thus, given the broad range of sizes and colors for a single product, controlling inventory risk is a major challenge in the shoe business with its small-lot, multi-type format, especially a burden for a brick-and-mortar outlet whose floor space is limited. The retail innovator who can solve this major challenge will have a real sustainable moat advantage. Despite its long profitable history and efficient manufacturing facilities, and even if it had outsourced to cheaper overseas production bases, Dexter had not yet solve this major challenge.

In Japan, this major challenge in the shoe industry faced by Dexter was compounded by the multi-tiered shoe distribution market, with distributors and wholesale firms at various stages between manufacturers and consumers. The structure remained even after a drastic shift to overseas production sites in the 90s, with the accumulated distribution costs being passed along in retail shoe prices. Japanese shoe retailers hedged inventory risk via product-return programs with manufactures and wholesale firms, while the upstream side added return-related costs in wholesale prices. Like Dexter, numerous shoe manufacturers and retailers have failed since the late 90s, including Asahi Corporation in April 1998, Americaya Shoes in April 1999, and the once-mighty Kutsu-No-Marutomi in Dec 2000.

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Masahiro Miki is the low-profile secretive billionaire founder of ABC Mart who worked alongside employees in stores during weekends. Miki owns around 30% of ABC-Mart and is ranked #11 on Forbes richest Japanese list with a net worth of $3.5bn. Not many people know that Miki-san is Korean-Japanese with a Korean name of Kang Jeong-ho, as he seldom shows himself in public. Like Dexter’s Harold Alfond who was an outstanding athlete and developed his passion for sports, Miki was an amateur boxer and sports lover. Miki, who had been interested in import clothing retail, switched to selling shoes when he realized that the Japanese shoe industry was not particularly competitive. Kokusai Boeki Shoji (International Trading Corp) was established in 1985 in Tokyo’s Shinjuku ward. Miki pursued brand businesses early on by securing domestic general-distributor rights to Hawkins in 1986 (it acquired trademark rights in 1995) and Vans in 1991 (it concluded a domestic trademark usage contract in 1994). This brand-management know-how has contributed greatly to ABC-Mart’s private brand-driven growth strategy. Miki entered the retail market in 1990 with the launch of ABC-Mart and opened four stores in central Tokyo that sold sneakers and work boots, riding the casual fashion trend at that time. In the late 90s, ABC-Mart accelerated the rollout of self-branded products utilizing the trademarks it had acquired, and broadened coverage by adding business and walking shoes.

ABC-Mart compounded its market value nearly 10-fold since 2000 to $4.4bn by streamlining the procurement structure and removing the middlemen from Japan’s multi-tiered shoe retailing structure and built a high-margin format. This was made possible with two innovations.

First, ABC-Mart…

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ABC-Mart also sought to solve the inventory challenge with an innovative in-store service that allows customers to directly place orders for shoes that are not in stock at its brick-and-mortar stores to the shoe retailer’s web outlet. Customers can place orders for shoes of any desired model or size from the in-store terminal when they are out of stock at the outlet they visit. They pay for the shoes there and then, and can choose to arrange home delivery or pick up the goods the next time they visit. The number of outlets that provide such services is around 600, roughly 80% of all ABC-Mart stores in Japan. The iPhone-based service, called “iChock,” minimize missed business opportunities due to items being out of stock as well as to reduce inventory at each store and improve capital efficiency.

With its extensive name-brand lineup and exclusive private-brand products, sales has been brisk despite the April 1 2015 sales price hike, posting a 12th year record high profits. While ABC-Mart has been the poster child of deflation-era retailing, with stores advertising shoes for as little as ¥2,900 ($28) and ¥3,900, along with clearance sales, it has found success in rolling out products that appeal to fashionistas who do not mind paying a little extra for style. ABC-Mart stores are also hot spots for many Chinese tourists who buy four or five pairs at once. ABC Mart found overseas success with over 180 stores, with over 150 stores in South Korea and the rest in Taiwan.

In Aug 2012, ABC-Mart also completed the $138m purchase of LaCrosse Footwear, a rival to Berkshire’s HH Brown and Justin Brands. Workwear consumers of the LaCrosse and Danner brands in America include people in law enforcement, transportation, mining, oil and gas exploration and extraction, construction, government services and other occupations that require high-performance and protection footwear as a critical tool for the job. Outdoor consumers include people active in hunting, hiking, outdoor cross-training. LaCrosse purchased storied bootmaker Whites Boots in 2014. Both these brands also sell well in Japan.

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We have emphasized in earlier articles our observation that most Asian companies are “one-man-shop” operations with the founder making all the decisions. The willingness to build a culture of decentralization/ empowerment and invest in a system to cascade decision rights throughout the organization is an important signal that the founder desires and cares to scale up the company in a sustainable manner by not hoarding knowledge. Technology is an important tool in empowering the employees and in giving them an informational advantage in their respective roles and responsibilities at work.

Sam Walton himself solved the major problem of inventory and working capital to scale up the business by having a continual commitment in the intangible IT investments. Sam Walton’s penchant for a reliable and speedy information system is grounded in pragmatism: “Once we had those scanners in the stores, we had all this data pouring into Bentonville over phone lines. I like my numbers as quickly as I can get them. The quicker we get that information, the quicker we can act on it. What I like about it is the kind of information we can pull out of it on a moment’s notice.”

The story of Dexter Vs ABC-Mart also reminds us of Kmart Vs Wal-Mart. The once mighty Kmart was bigger than Wal-Mart in 70s and 80s; it declared bankruptcy on Jan 22, 2002. K-Mart is the typical cheap gets cheaper, cigar-butt value trap with the halo of a successful founding entrepreneur. While Wal-Mart commits itself in IT investments in order to scale up its store network in a sustainable manner, Kmart was busy acquiring various companies that include Furr’s Cafeterias of Texas, Bishop’s Buffet chain, pizza-video parlors, Payless Drug Stores, the Sports Authority, and OfficeMax as outlets for its retained earnings. By the end of 80s, Kmart was at least ten years behind Wal-Mart in its operational capabilities. As Kmart fell ever further behind, its need for outside-of-the-core growth platforms became a self-fulfilling prophecy. Wal-Mart now collects more data about consumers than anyone in the private sector. Wal-Mart mined this data into actionable business intelligence to ensure that consumers have the products they want, when they want them, and at the right price. For example, they have learned that before a hurricane, consumers stock up on food items that do not require cooking or refrigeration.

Ironically, IT investments was the tipping point factor that “killed” Kmart. It spent $2b in 2000/01 – and using IBM, the same IT supplier as Wal-Mart. The key Is discipline and integrating technology into business model to achieve “emptiness” in an indestructible intangible asset: Wal-Mart shared its info with supplier in exchange for greater discounts to integrate with its EDLP (everyday low prices) business strategy, whilst Kmart simply “invest” and “collect data” without a purpose.

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Entrepreneurship generates substantial emotions because it is an extreme context in terms of time pressures, uncertainty and the extent of personal consequences tied up in the fate of the firm. People are heterogeneous in their motivations for engaging in the entrepreneurial process. Understanding the micro-foundations of entrepreneurial action and the notion of hot cognition, the emotions that influence cognitive processing in the entrepreneurial context, and the “why” underlying these activities is critical for the value investor to avoid costly investment mistakes. The emotions generated from making progress on a challenging entrepreneurial task – solving the inventory problem in order to scale up – increases the entrepreneur’s scope of attention, hot cognition and (access to) resources and impact subsequent activities in the entrepreneurial process.

Both Sam Walton and Masahiro Miki faced a lot of resistance and doubts when they spent heavily on IT system – the money could have been spent on tangible assets like property. In the end, the scale and constancy of the investments involved in building the indestructible intangibles discourage imitators and disrupts complacent incumbents. They “stick to their guns” and that made all the difference to understanding the wide-moat advantage that they have built up. The Heart of entrepreneurship is summed up best by Sam Walton in his inspiring autobiography Made in America:

“It is a story about entrepreneurship, and risk, and hard work, and knowing where you want to go and being willing to do what it takes to get there. It’s a story about believing in your idea even when maybe some other folks don’t, and sticking to your guns.”

Both Sam Walton and Masahiro Miki are unwavering in their core values, just like the Bamboo: Even through the strongest hurricanes, the bamboo will bend but never break; when covered with snow, it will patiently wait for it to melt down, and then rise up And in the end, the bamboo stands tall, green and beautiful. For the traditional Chinese, the bamboo represents the value of “uprightness”. At Moat Report Asia, we are of the conviction that the future is created one Bamboo Innovator at a time. If you also share in our values and investment process, and support our conscious efforts to promote entrepreneurialism in Asia, we invite you to join us in this uplifting journey to make a positive difference to society.

Warm regards,

KB

The Moat Report Asia

www.moatreport.com

http://accountancy.smu.edu.sg/faculty/profile/108141/KEE-Koon-Boon

A new monthly issue of The Moat Report Asia is now available!

Access the in-depth idea presentation:

http://www.moatreport.com/members/

This month, we highlight a wide-moat innovator who is the #1 in Asia in a patented automotive electronics part that is part of the fast-growing Advanced Driver Assistance System (ADAS) market worth >$22bn by 2018, doubled from $11bn in 2014. The ADAS market is driven by more stringent safety requirements from governments forcing the automotive industry to develop automotive electronics solutions to increase vehicle safety. [Company’s name] is the third-largest in the world behind Valeo (FR EN) and Bosch. It has >50% market share in new cars sold in China, and the installation rate of this ADAS product on China’s auto is still low (35%+ on new cars vs 80%+ in developed markets). Established in 1979 by founder and Chairman Mr. C, [Company’s name] is one of the rare Tier-1 automotive suppliers in Asia to major OEM car makers that include Ford, GM, Daimler, Hyundai, Nissan, China’s top 10 auto companies such as Great Wall Motor, thereby directly shipped to them and involved in their R&D processes and early stage processes of concept car design and prototyping, creating a pre-emptive advantage in winning new orders. Over the past 36 years, [Company’s name] has forged formidable competitive advantages in scale, product quality, technological know-how and R&D capabilities and in May 2012, [Company’s name] outgunned illustrious industrial automotive giants Valeo (founded in 1923) and Bosch (founded in 1886) to sign a breakthrough global 10-year contract with GM, with the commencement of worldwide shipment to 18 countries and 25 factories at the end of 2016.

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• Get The Moat Report Asia – a monthly in-depth presentation report of around 30-40 pages covering the business model of the company, why it has a wide moat and why the moat may continue to widen, a special section on “Inside the Leader’s Mind” to understand their thinking process in building up the business, the context – why now (certain corporate or industry events or groundbreaking news), valuations (why it can compound 2-3x in the next 5 years), potential risks and how it is part of the systematic process in the Bamboo Innovator Index of 200+ companies out of 15,000+ in the Asia ex-Japan universe.
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The in-house investigation into the accounting scandal relates to the underestimation of costs for 9 out of the 250 projects using the percentage-of-completion (POC) accounting method: 4 projects totalling ¥6bn at the power systems company, 4 projects totalling ¥30bn at the social infrastructure systems company and one project totalling ¥14bn at the community solutions company. Toshiba derived around 11% of operating income from its power and social infrastructure business. This is the second accounting investigation in less than two years for Toshiba, which has twice delayed reporting its earnings for the year ended in March because of irregularities. The new panel’s probe will extend to Toshiba’s 593 consolidated subsidiaries, including electrical engineering giant Westinghouse Electric, owned by Toshiba since 2007.

Toshiba and one of its listed subsidiaries, Toshiba Plant Systems & Services (1983 JP, MV $1.2bn), are also members of the JPX-Nikkei Index 400, which was started last year to showcase Japan’s best shares to institutional investors and shame executives of companies that weren’t picked into improving capital efficiency to make the cut. It selects the 400 companies in Japan with the highest return on equity and profit over the past three years. Corporate governance is another factor in choosing the members. The gauge recalculates its constituents every year using data from the last business day of June, and publishes the results in August. Sony Corp was among 31 members that got replaced in 2014. Interestingly, Toshiba has four outside board directors, an apparent sign of good “corporate governance” to keep checks and balances on the managers. Toshiba is now in a race to report its restated earnings before the June 30 deadline. Toshiba risks losing the attention of about ¥650bn tracking the JPX-Nikkei 400 in exchange-traded and mutual funds should it get kicked out of the JPX-Nikkei Index.

We wish to highlight the area of revenue recognition and the accounting for long-term contracts, in particular the percentage-of-completion (POC) accounting method, which has received relatively little inspection from academics and practitioners. There are important implications for value investors given that the POC accounting method is common across industries from construction/infrastructure/property and defence to software.

In essence, long-term contracts present special problems for revenue recognition, which allows for both the POC method and the completed contract method (CCM). Under the CCM, no revenue is recognized until the project is 100% complete; and, the related project costs are held as inventory. The POC method recognizes revenue and costs as measurable important progress milestones on a project (output-based measure) or based on a ratio of costs incurred to date over expected total contract costs (input-based measure 1: cost-to-cost method) or based on comparing measures such as labor hours, labor dollars, machine hours or quantities of material consumed to date to the total quantity estimated forte entire project (input-based measure 2: efforts-expended method). Under the POC method, managers can opportunistically manipulate the percentage of completion to recognize revenue prematurely and conceal contract overruns.

The following can be manipulated to affect revenue recognition:

• Concealing subcontractor, labor and other project costs
• Subjective estimation of costs to complete the projects
• Shifting costs between projects
• Improper allocation of indirect overheads to projects
• Misallocation between project and non-project costs
• Improperly deferring project costs
• Premature expensing of pre-contract costs
• Commingling of project and other costs
• Recognition of unapproved change orders and claims that have no basis for inclusion in contract value
• Setting improper project milestones where cost-to-cost is the more appropriate basis

Note: Should the above red flags be found, value investors should adjust downward the revenue by an amount that is the difference between unbilled receivables (or amount due from customers in contract work) and the work-in-progress (WIP).

Past prominent cases involving POC accounting fraud include:

• Defence contractor Halliburton (HAL US) had increased revenue by $434m during 1998-2001 by booking cost overruns on construction projects before clients agreed to pay for them. In the wake of the recent Toshiba scandal, South Carolina Electric & Gas, a client of Westinghouse and its business partner Chicago Bridge & Iron (CBI US), had filed a petition on the incremental capital costs on a nuclear plant construction that total $698m, of which $539m are associated with delays and other contested costs.
• Data-mining software company MicroStrategy (MSTR US), worth $31.1bn at its peak as compared to its present market cap of $2bn, had recognized over half ($17.5m) of the licensing revenue immediately in a $27.5m multi-year licensing agreement with NCR. The foundation of MicroStrategy’s product had been its corporate data-mining program which combs through terabytes of data looking for interesting relationships; MicroStrategy’s customers McDonald’s, Wal-Mart, NCR could use the program to detect customer buying patterns. According to the NCR order, because MicroStrategy’s software license sales were part of multiple-element transactions that included other services such as product support and development and consulting, the company was required to apply POC accounting. However, for a number of transactions that were subsequently restated due to a misapplication of the accounting standard, MicroStrategy had (1) improperly separated software license sales from their service elements and (2) characterized revenue in multiple element transactions as product or software revenue and recognized it at the time of the transaction. Without this $17.5m addition to third quarter revenue in 1999, MicroStrategy would have reported a revenue decline of 20% from the previous quarter and a loss instead of a profit.
• Similar accounting issues to MicroStrategy arose for…

Recent accounting scandals in Asia who had potentially abused the POC accounting method include water treatment company Sound Global (967 HK, $1.36bn) whose auditors identified audit issues of missing RMB2bn cash shortfall and had reported matters to Singapore’s Ministry of Finance in an announcement on May 4, around three months after allegations of fraud by Emerson Analytics which the company denied with the media supporting the management and blasting the short-seller for the unfair attack. For instance, unbilled receivables (amount due from customer for contract work) at Sound Global soared over five-folds from RMB203m in FY09 to RMB1.1bn in FY13, representing around 15% and 35% of sales respectively, an indication of aggressive revenue recognition before projects are actually completed in the subjective use of the POC accounting method. Managers often opportunistically manipulate the estimates under the POC accounting method to inflate revenue and profits to achieve compliance with existing and future debt covenants and to raise more external financing in debt and equity. Note that the total debt at Sound Global had jumped from RMB227m in FY09 to RMB3.8bn in FY13.

Another example is Japanese vacuum machinery company Ulvac (6728 JP, MV $796m). Around 2010, Ulvac reported that its full year ended Jun 2010 sales were down 1% and operating profit was up 38%. However, the result was due to the switch to POC accounting method and aggressive accounting in revenue recognition much earlier. Interestingly, Ulvac disclosed in the footnotes that had it used the same revenue recognition method as before, its sales would have been down 21% and there would be a loss. Since Jun 2010, Ulvac’s share price is flat, underperforming the 100% rise in the Nikkei index.

Ulvac (TSE: 6728 JP) – Stock Price Performance 2010-2015

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When Samuel Insull was not named the president of what is now known as General Electric, he left and went on to build a electricity utilities empire using financial engineering and complex holding companies structure carrying out M&As and became one of the richest man in the world with a personal worth of over $150m (over $1.7bn in today’s dollars). To pay for expansion, Insull had sold low-price bonds and stock. Over a million middle-class Americans bought in – but their investments were made worthless by the Great Depression. Overnight, Insull went from a hero on the cover of Time magazine to the villain who had stolen the people’s money. It was said that before Enron, there was Insull. Charged with fraud, Insull was tried in 1934 and acquitted of the charges. But his reputation was destroyed, and he left the country for good. Four years later, Insull died of a heart attack in the Paris subway in 1938 with 84 cents in his pocket.

When financial and accounting wizards Harry Sonneborn and Samuel Insull left Ray Kroc and Thomas Edison respectively, they were in a “percentage of completion” mode in not being able to build an idea larger than themselves to complete the work. The awkward Dreamer and the suave professional Accountant is the “completed contract”. When separated from the Dreamer and her vision, the Accountant often flounders and loses his Way. Similarly, the technical interpretation and application of the POC accounting method cannot be separated from the wide-moat business model analysis of the company since the long-term nature of the contract with the customer determines the economic substance and viability of the business’ work in progress, of an idea larger than oneself.

Warm regards,

KB

The Moat Report Asia

www.moatreport.com

http://accountancy.smu.edu.sg/faculty/profile/108141/KEE-Koon-Boon

A new monthly issue of The Moat Report Asia is now available!

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This month, we highlight a wide-moat innovator who is the #1 in Asia in a patented automotive electronics part that is part of the fast-growing Advanced Driver Assistance System (ADAS) market worth >$22bn by 2018, doubled from $11bn in 2014. The ADAS market is driven by more stringent safety requirements from governments forcing the automotive industry to develop automotive electronics solutions to increase vehicle safety. [Company’s name] is the third-largest in the world behind Valeo (FR EN) and Bosch. It has >50% market share in new cars sold in China, and the installation rate of this ADAS product on China’s auto is still low (35%+ on new cars vs 80%+ in developed markets). Established in 1979 by founder and Chairman Mr. C, [Company’s name] is one of the rare Tier-1 automotive suppliers in Asia to major OEM car makers that include Ford, GM, Daimler, Hyundai, Nissan, China’s top 10 auto companies such as Great Wall Motor, thereby directly shipped to them and involved in their R&D processes and early stage processes of concept car design and prototyping, creating a pre-emptive advantage in winning new orders. Over the past 36 years, [Company’s name] has forged formidable competitive advantages in scale, product quality, technological know-how and R&D capabilities and in May 2012, [Company’s name] outgunned illustrious industrial automotive giants Valeo (founded in 1923) and Bosch (founded in 1886) to sign a breakthrough global 10-year contract with GM, with the commencement of worldwide shipment to 18 countries and 25 factories at the end of 2016.

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When the late German entrepreneur Detlev Louis passed away in Oct 2012 at the age of 93, the eponymous-named firm endured and continued to grow to extend its as Europe’s #1 for motorcycle clothing, helmets and accessories with 74 stores in Germany and Austria and annual sales of Euro 270m. This was despite the setback of the sudden death of the second generation Stephan Louis in Jul 2011 due to heart attack at the age of 57, as well as changing consumer dynamics with the disruption of online ecommerce that bankrupted its rival Polo in Dec 2011.

The wide-moat characteristics of Detlev Louis that attracted Buffett to pay $450m is a microcosm of Berkshire Hathaway, itself a collection of companies acquired over the past 50 years to propel it to eclipse General Electric to become the largest conglomerate in the world worth $365bn and perched at #4 in the Fortune 500 list. Berkshire’s essence is that of a family business innovator, run by executives who consider themselves owners nurturing the company for the next generation, rather than hired hands. And sellers of businesses sometimes sell out to Berkshire at a price less than what they could have received elsewhere.

When asked in 2008 why family business owners would want to sell to Berkshire, Buffett quipped:  “You can sell it to Berkshire, and we’ll put it in the Metropolitan Museum; it’ll have a wing all by itself; it’ll be there forever. Or you can sell it to some pawn shop operator, and he’ll take the painting and he’ll make the boobs a little bigger and he’ll stick it up in the window, and some other guy will come along in a raincoat, and he’ll buy it.” In other words, Berkshire offered the family businesses and entrepreneurs a sense of a permanent home and the autonomy to continue running the business, as argued by Lawrence Cunningham, author of the insightful book Berkshire Beyond Buffett. And this distinctive corporate culture of permanence and decentralized autonomy has been a core set of values and the glue that unites Berkshire’s bewildering variety of companies, such that bigger is not riskier and there isn’t the (steep) holding company discount to its book asset value.

Top Left: The late Detlev Louis in a photo with his congenial wife Ute; Top Right: Buffett the biker at the AGM; Bottom: Workman (TSE: 7564 JP) – Stock Price Performance 1997-2015

Buffett and Munger also emphasized the point of Berkshire’s culture at the AGM 2015:

Shareholder question from Lawrence from Germany: “You are heralded for your integrity. How can investors judge the state of Berkshire’s culture long after the two of you are gone?”

Buffett: “I think you will be very pleased with the outcome. I think BRK’s culture runs as deep as any large company should. A few days ago, the company closed on a transaction in Germany. The owners had spent 35 years or more building a retail business… it’s a vital part of Berkshire to have a clearly defined, deeply embedded culture that pervades the company. Once Charlie and I aren’t around, it will be clear that it’s not a force of personality, that it’s institutionalized.”

Munger: “As I said in the annual report, I think BRK is going to do fine after we’re gone. In fact, it will do a lot better… but at any rate, it will never again at the rate it did in the early years. There are worse tragedies in life.”

Underlying the corporate culture traits at Berkshire is the “missing ingredient” that we hope will help spark the generation of deeper questions in understanding the persistency of wide-moat: Imprinting.

Imprinting is a learning process that initiates a development trajectory that produces persistent outcomes. Building on the work of Stinchcombe (1965) in his work “Social Structure and Organizations”, organizational research on imprinting has highlighted the enduring impact of prior history on organizational outcomes by demonstrating how organizations assume elements of their environment that persist well beyond their founding phase. Imprinting has to take place and take root before the succession process can become successful.

We have observed that transgenerationally entrepreneurial families possess entrepreneurial legacy, the reconstructed narratives of the family’s entrepreneurial behavior and resilience that motivate and give meaning to entrepreneurship with today’s risks in perspective, motivating current and next-generation leaders to engage in strategic activities that go beyond ordinary succession and thereby nurture transgenerational legacy. Actions that leaders take and routines that develop during periods of environmental stress and organizational change, such as frugality in spending and calculated boldness in expansion during a severe recession, lead to profound differences in structures, strategies, and product offerings that become “imprinted” in that they persist over time. Transgenerational entrepreneurial family firms are stronger and quicker in creating new products and services as niches develop, enter new markets, adopt new technologies, and implement new ways of organizing business activities.

At Louis, the imprinting over the years enabled the firm to endure the death of both the founder and the second-generation. Founded in 1936 as a small repair shop and built by Detlev since 1946, the firm was a pioneering innovator in multi-channel sales offering an extensive range of over 32,000 products, launching its first motorcycle accessories mail-order catalogue in 1967. This was a time when motorcycle was pushed massively into the background by the car. But Detlev believed in the unique fascination with motorcycling in which he developed tuning and accessories for his races. The wide range of products, reasonable prices and almost always good services made the consumer experience at Louis more enjoyable, garnering it a loyal customer base of a million mostly very satisfied customers. The popularity of Louis stores prompted the development of a modern logistics center with conveyor technology in 1991 to supply its growing network of store branches. In 1997, the reach into the consumer was extended by online trade which generated around 20% of its sales in 2014. Throughout its history, Louis has taken care to imprint the values of economic foresight, openness to new ideas, hard work and excellent people management into its corporate culture and into its successors Nico Frey and Joachim Grub- Nail. Thus, value investors can utilize the imprinting idea to generate interesting general questions to assess the sustainability of the wide-moat beyond ordinary succession. These include:

• What was the breakthrough or innovation story in the corporate history (eg first motorcycle accessories catalogue) that enabled the company to grow and differentiate itself amidst the competition? Did the founder and management sought to imprint the intangible values (eg determination and economic foresight in establishing multi-channel sales) in the culture?
• How did the firm cope during environmental stress (eg online ecommerce threat, price war amongst rivals), organizational change (death of second generation), and periods of expansion (eg complacent vs sober in setting up the modern logistics center)? Were the intangible values (eg frugality in spending, openness to new ideas, boldness) imprinted?

To run a distribution and store network effectively takes a decentralized “core-periphery” system, an essential source of “emptiness” in Bamboo Innovators in which fibers of greatest strength occur in increasing concentration toward the periphery of the bamboo, a powerful architecture from a builder’s viewpoint. At the “periphery”, the Louis stores have penetrated into the hearts of the motorcycle culture. At the “core”, the centralized support of the modern logistics center enabled the vitality of the stores to provide a comprehensive range of products with efficient inventory and working capital management. The core-periphery business model at Louis is a microcosm of Berkshire itself: Operating managers at the “periphery” like Louis with autonomy in doing their jobs are greatly motivated by the trust and empowerment to outperform. The operating subsidiaries are all united by the distinctive corporate culture and values at the “core”.

Are there similar Louis in Asia? How can value investors use imprinting and the core-periphery business model to identify these family innovators?

One such transgenerational Bamboo Innovator is Japan’s Workman Co (7564 JP, MV $1.1bn), dubbed the “Uniqlo of workwear market” and owned by the Tsuchiya family with a majority control of over 52%. Established in 1982 as an “artisan workshop” in Gunma prefecture, Workman is a specialty retailer of work uniforms and related goods including work gloves and safety shoes, operating 700 stores (both its own stores and franchised stores) in 41 prefectures in Japan, generating around $49m in profits from $404m in sales in FY14. Since its listing in 1997, it has compounded over 600% as compared to a flattish Nikkei 225 index.

Like Louis, Workman offers a wide range of over 7,500 items that meet customers’ needs.  Workman uses sales data and other feedback from its outlet managers to jointly develop with manufacturers its own brand of products that are tailored to meet specific customer needs and price demands, in the same way that Uniqlo is both developing and making its products. Own-brand products make up over 60% of Workman’s product line-up. The remaining products sold are purchased from manufacturers produced nearly exclusively for it at low prices in exchange for assuming risks of stock valuation losses. The firm enjoys economies of scale as the number of its outlets has increased substantially. In addition, the firm has found ways to effectively reduce costs by procuring goods from overseas and by using private brand products, especially for consumable supply goods. For instance, a set of dozen cotton work gloves is priced at around ¥160, half of the regular market price.

Workman is a member of the low-profile unlisted Beisia (Iseya) group of companies, a large distribution group founded in 1958 in the northern Kanto region with ¥8,300bn ($69bn) in group sales, making it one of the top 20 business groups in Japan. which also includes the shopping mall chain Beisia (107 stores in Tokyo metropolitan area), the home center Cainz (188 stores throughout Japan), the convenience store chain Save On (582 stores in Kanto district), car parts and accessories chain AutoR (60 outlets). Yoshio Tsuchiya is the chairman of Workman since 1984 and is also chairman of Beisia since Jun 2009. Like Berkshire and Louis who have imprinted distinctive values into the culture, the Beisia group imprinted the unconventional idea in hierarchical Japan of a profit-sharing system in 1967 and was an early pioneer in adopting the IT system to be more efficient in its inventory management in 1974. Beisia was also an innovator in management system with the overseas training system in 1975. Beisia opened its modern Isesaki logistics and distribution in 1980, followed by the Tokyo Information Center in 1984 in the application of data analytics of supplier and consumer intelligence.

Importantly, Workman has the core-periphery business model in applying the know-how at the “core” of the Beisia group to maintain efficient systems for distribution, inventory management and information gathering and application. Due to its clout and dominance, Workman receives income in the form of centre fees from…

There is an interesting story imprinted about the frugal culture, the mechanism and unconventional measures built and maintained throughout the company’s history that allows Workman to sell products at amazingly low prices. In its new product presentation launches in which Workman unveils new products to the owners of its franchise stores, the highlight of the presentation event is a fashion show featuring new work wear. All of the models that appear in the show are young people who are Workman’s newly recruited employees. “It would cost about 100,000 yen to hire one professional fashion model for the show. So we use our employees instead,” said Workman’s president with an unconcerned look. Workman is determined to cut costs whenever it can do so. There is simply no room for compromise about this.

Indeed, there is no compromise at Workman, the low-profile Asian Bamboo Innovators, and BRK’s operating businesses in imprinting these BERKSHIRE values elucidated by Cunningham and value investors will do well by observing and assessing the imprinting to identify the longevity of the wide-moat innovators:

Budget conscious, as in thriftiness

Earnest, as in keeping promises

Reputation, as in personal and corporate integrity

Kinship, in terms of legacy and a family orientation

Self-starters, as in entrepreneurial behavior

Hands off, as in delegating decisions and responsibility

Investor savvy, in terms of capital investment

Rudimentary, as in easy-to-understand businesses

Eternal, as in a long-term perspective

Warm regards,

KB

The Moat Report Asia

www.moatreport.com

http://accountancy.smu.edu.sg/faculty/profile/108141/KEE-Koon-Boon

A new monthly issue of The Moat Report Asia is now available!

Access the in-depth idea presentation:

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This month, we highlight a wide-moat innovator who is the #1 in Asia in a patented automotive electronics part that is part of the fast-growing Advanced Driver Assistance System (ADAS) market worth >$22bn by 2018, doubled from $11bn in 2014. The ADAS market is driven by more stringent safety requirements from governments forcing the automotive industry to develop automotive electronics solutions to increase vehicle safety. [Company’s name] is the third-largest in the world behind Valeo (FR EN) and Bosch. It has >50% market share in new cars sold in China, and the installation rate of this ADAS product on China’s auto is still low (35%+ on new cars vs 80%+ in developed markets). Established in 1979 by founder and Chairman Mr. C, [Company’s name] is one of the rare Tier-1 automotive suppliers in Asia to major OEM car makers that include Ford, GM, Daimler, Hyundai, Nissan, China’s top 10 auto companies such as Great Wall Motor, thereby directly shipped to them and involved in their R&D processes and early stage processes of concept car design and prototyping, creating a pre-emptive advantage in winning new orders. Over the past 36 years, [Company’s name] has forged formidable competitive advantages in scale, product quality, technological know-how and R&D capabilities and in May 2012, [Company’s name] outgunned illustrious industrial automotive giants Valeo (founded in 1923) and Bosch (founded in 1886) to sign a breakthrough global 10-year contract with GM, with the commencement of worldwide shipment to 18 countries and 25 factories at the end of 2016.

Paid subscribers get:

• The Monthly Moat Report Asia (20 issues)
• Bonus Content: The Weekly Bamboo Innovator Insight Articles (>70 Issues)
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• The weekly insight is a teaser into the opportunities – and pitfalls! – in the Asian capital jungles.
• Get The Moat Report Asia – a monthly in-depth presentation report of around 30-40 pages covering the business model of the company, why it has a wide moat and why the moat may continue to widen, a special section on “Inside the Leader’s Mind” to understand their thinking process in building up the business, the context – why now (certain corporate or industry events or groundbreaking news), valuations (why it can compound 2-3x in the next 5 years), potential risks and how it is part of the systematic process in the Bamboo Innovator Index of 200+ companies out of 15,000+ in the Asia ex-Japan universe.
• Our paid Members from North America, Europe, the Oceania and Asia include professional value investors with over $20 billion in asset under management in equities, some of the world’s biggest secretive global hedge fund giants, and savvy private individual investors who are lifelong learners in the art of value investing.

Over the past 36 years, [Company’s name] has forged formidable competitive advantages in scale, product quality, technological know-how and R&D capabilities and in May 2012, [Company’s name] outgunned illustrious industrial automotive giants Valeo (founded in 1923) and Bosch (founded in 1886) to sign a breakthrough global 10-year contract with GM, with the commencement of worldwide shipment to 18 countries and 25 factories at the end of 2016. The journey has not been easy for Mr. C who recounted his days of carrying the same brief case containing the auto parts to knock on doors..

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Q: “Can you share with us what is so difficult about making these [Company’s flagship product] and automotive electronics parts beyond having more capital and money?”

Mr. C: “Time. Time is the most difficult thing. The closed, protected automotive industry demands an exceptionally high standard of safety, durability and reliability of the 8,000 to 15,000 auto parts that go into the car, even more so for automotive electronics products since these are integrated into a system and platform as opposed to some stand-alone parts. It’s not a case of whether you can produce the parts with high quality and people will then use them.

Only AFTER you produce the parts and somehow manage to convince someone to test it for at least a year or more, ensure that the parts stay defect-free, zero PPM (parts per million), under rigorous test conditions, can the OEM carmaker say, OK, we will try it. But the actual truth is, when you have produced what you think is a high quality part and approach the OEM carmakers, they will all say, ‘Why don’t you bring this to other factories to test it out first. If the others are ok, we will look at it. Every car factory will say the same to you. No one wants to be the guinea pig, the lab rat. As a result, you will never get in to their supply chain.

To win their trust is not easy. I remembered in those years, I would carry the same brief case that I use to knock on doors. In it contained the auto parts. Everyone would say that they are interested and to send them the samples. However, when the samples are sent, the rock sinks to the ocean and there is no news. Hence, time is the biggest cost and the most difficult thing.

One might think that automotive electronics products could be similar to consumer electronics parts. Hence, the barriers to entry are low and there could be new entrants. This thinking could not be more wrong.

On our flagship product itself, do you know that a [Company’s flagship product] would have to withstand extreme hot and cold temperature changes, withstand vibration, stay water-resistant, anti-dust, anti-humidity, anti-signal disruption, and a battery of tests. Amongst these tests is the requirement to continue functioning in the sudden change from minus 40 degrees Celsius to 85 degrees Celsius. And our engineers have to go with the OEM carmakers to actual sites in Northern Europe, China’s Heilongjiang and the Gobi desert to do the tests.

[Company’s name] is proud that our production quality has reached over 36 months (and still running) of zero PPM (parts per million) defect. This is the real reason why we are able to win Valeo and Bosch and win the hearts of our customers to place orders with us.

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Bosch India (NSI: BOSCHLTD) – Stock Price Performance 1994-2015

In the ruthless cut-throat automotive industry, the fact that Bosch India (BOS IN, MV $11bn) and [Company’s name] have strikingly similar EBITDA margin at 15.6% and ROE of around 14.5% (although Bosch India is net-cash but has low dividend payout) speaks volume about [Company’s name]’s wide-moat advantage in securing long-term pricing power and earnings sustainability with the major OEM carmakers by winning their trust to strike long-term partnership in global platform deals. Bosch India trades at an expensive valuation premium of EV/EBITDA 45.7x as compared to 15x for [Company’s name].

While [Company’s name] has a dividend yield of 2.2%, it is not cheap in valuation at EV/EBIT 18.4x and EV/EBITDA 15.1x. We believe that the key to valuation success for an innovative automotive supplier is a Tier-1 status (as opposed to the “cheap” Tier-2 or 3 players) and the long-term visibility and sustainability in generating quality growth by offering products and technology that play into the upcoming movement towards either (1) “Efficiency”: fuel efficiency, emissions and environmental footprint of a car, or/and (2) “Content”: comfort, convenience and safety features that help improve the ownership experience of the automobile. Bosch India belongs to the “Efficiency” category when it was re-rated since its tipping point moment in 2006 when it set up the manufacturing facilities for CRDi-based passenger diesel engine system in India and market value compounded 8-fold in 9 years to $11bn while sales climbed 150% over the same period to generate a doubling in earnings growth from Rs5.5bn in FY06 to Rs10.5bn ($160m) in FY14. [Company’s name] belongs to the “Content” category and is also one of the rare few Tier-1 auto suppliers in Asia. We believe the technical superiority of [Company’s name] in developing low-cost innovative solutions that enabled it to command a >50% market share for new cars in China deserves to command a higher valuation.

We are impressed by Mr C’s dedication, patience and focus in not only building up a rare Tier-1 supplier capability but also in forging a corporate culture that feels like an enterprise of engineers, reminding us of automotive parts innovator Gentex (GNTX US, MV $5.2bn)/John Bauer. [Company’s name] has around 400 engineers and R&D specialists, comprising 20% of the workforce, a similar ratio to Gentex. We like how [Company’s name] has consistently reinvested back into the business to develop its R&D and new product innovation capabilities beyond its flagship product that are now building up sales momentum as well as set the company on a long-term growth trajectory path in the fast-growing multi-billion ADAS market and the race towards the autonomous car.

As Mr C puts it aptly:

“What’s next for [Company’s name] isn’t about how many cars there are; it is about how electronic the cars can be. There is great long-term potential for automotive electronics parts in the future car, which will jump from the present 10% of the total cost of making a car to 40%. To capture this long-term opportunity, [Company’s name] will continue to build upon our 36 years of accumulated know-how, capabilities, global partnership platform and underlying trust with our global clients to enable [Company’s name] to shine bright in the global automotive industry!”

Who is Mr. C and this wide-moat Bamboo Innovator?

A new monthly issue of The Moat Report Asia is now available!

Access the in-depth idea presentation:

http://www.moatreport.com/members/

Warm regards,

KB

The Moat Report Asia

www.moatreport.com

http://accountancy.smu.edu.sg/faculty/profile/108141/KEE-Koon-Boon

A new monthly issue of The Moat Report Asia is now available!

Access the in-depth idea presentation:

http://www.moatreport.com/members/

Paid subscribers get:

• The Monthly Moat Report Asia (20 issues)
• Bonus Content: The Weekly Bamboo Innovator Insight Articles (>70 Issues)
• Bonus Content: Access to the Members’ Forum
• Bonus Content: Videos and Presentations by Thoughts Leaders, Entrepreneurs and Business Leaders in Asia

• The weekly insight is a teaser into the opportunities – and pitfalls! – in the Asian capital jungles.
• Get The Moat Report Asia – a monthly in-depth presentation report of around 30-40 pages covering the business model of the company, why it has a wide moat and why the moat may continue to widen, a special section on “Inside the Leader’s Mind” to understand their thinking process in building up the business, the context – why now (certain corporate or industry events or groundbreaking news), valuations (why it can compound 2-3x in the next 5 years), potential risks and how it is part of the systematic process in the Bamboo Innovator Index of 200+ companies out of 15,000+ in the Asia ex-Japan universe.
• Our paid Members from North America, Europe, the Oceania and Asia include professional value investors with over $20 billion in asset under management in equities, some of the world’s biggest secretive global hedge fund giants, and savvy private individual investors who are lifelong learners in the art of value investing.

• Detecting Accounting Fraud in Asia (Part 1), Sep 11, 2013
• Detecting Accounting Fraud in Asia (Part 2), Sep 16, 2013
• The Urgency for a Composite Measure to Detecting Accounting Fraud in Asia, Nov 24, 2014

“What seemed to be wrong with this income statement?” I would ask and engage value investors in a conversation discussing the limitations of western-based screening tools and techniques in financial statement analysis to analyze Asian companies.

“It was generated by a listed Chinese zipper company who claimed to be the ‘YKK of China’ with a diversified customer base of over 900 customers. Its zipper products are used in fashion and sports apparels, camping equipment, shoes, and bags by renowned brands. It also received the ‘PRC Top Ten Famous Zipper Brands’ in China. To perhaps make your job easier, a simple table of financial ratios from profit margins, ROE, cash conversion cycle (CCC) is provided. Interestingly, you might note that it is a company generating a ROE of 20.2% on profit net margin of 22.3% and trading at a modest valuation of Price-Earnings ratio 6.2x and Price-to-Book Value 1.6x, with downside protected by a seemingly healthy ‘net cash’ balance sheet with net cash comprising 27% of the market value of the company.”

“And we would stay on this income statement for whatever time it takes before someone points out the dog that didn’t bark,” I added.

Sometimes, there would be one or two people, often those who are open-minded and intellectually curious in their learning approach, who would point out: “The selling and distribution expense of RMB3m seems awfully low for a company generating RMB882m in sales for truckloads of zippers to be transported to over 900 of their customers’ factories in the different provinces.”

This zipper company is SGX-listed Fuxing Zipper (SES: DC9, Bloomberg: FUXC SP), down over 90% in market value. We will later illustrate how accounting tunneling fraud is carried out and the six new measures for value investors to employ to avoid such statistically-attractive fraudulent stocks. From the case of Fuxing, one of the apparent measures is based on the opportunistic shifting or deferring of operating expenses out of the income statement to boost profits artificially – often into the balance sheet items. But how do we can capture this? A possible measure is that of the “OP/OL ratio”, or “Other Payables/Operating Liabilities ratio” which we will elaborate upon later with the cases that we have observed to be a systematic phenomenon. In essence, we have observed that an OP/OL ratio over 40% leads to subsequent and future acts of accounting tunneling fraud in which corporate wealth and cash is tunneled out.

Fuxing Zipper (SES: DC9) – Stock Price Performance 2007-2015

As we have shared in earlier articles, transportation and logistical cost is a nightmare in China and emerging markets, estimated to account for 15 to 20% of the cost of doing business and of the GDP too by various sources that include World Bank and the Li & Fung group in an insightful presentation. The problem lies not only because of the geographical woes but also due to the regulatory licensing bottlenecks: “China’s logistics system is governed by nine separate ministries and commissions, which prevents the central government from regulating cross-provincial transport across China’s 31 provinces. Instead, local governments manage their transportation systems as provincial fiefdoms, often using local license rules and tolls to raise revenue. Thanks to high transaction costs, no trucking firm has yet established a nationwide network.”

The emerging Asian and Chinese companies engaging in accounting fraud often push operating expenses and overheads off the listed entities to related-party companies to boost artificially-high profit margins and ROE. For instance, an Asian consumer “brand” selling its “visible” products in supermarkets would usually shift the substantial expenses related to shelf-space placement to undisclosed related-party “distributors” and “agents” (called “tong lu” 通路 in the local language) to achieve the high profit margins and ROE that are attractive to investors. Most value investors focusing on financial ratio analysis do not realize that logistics, distribution and marketing costs in emerging Asian markets is around 15-20% of sales, instead of the 0.34% that this zipper company incurred. Like-minded value investors are often amazed that they have not seen what was now obvious to them. Thus, one simple new measure is to use the “Selling and Distribution expense as % of Sales” (Measure #1) as a sanity check on unrealistically low operating expenses that were deferred or shifted out of the income statement.

We wrote something in the article “BNSF + JB Hunt = Buffett + Munger = Lollapalooza! How About Asia?” about how logistical improvement throughout America has enabled the scaling up of retailers and businesses in a cost-effective way:  “The open innovation also enabled American companies such as Petco Animal Supplies, Pepboys Auto, The Container Store, Best Buy, Lowe’s, arts & craft retail chain Michael’s, to scale up their expansion in a cost-effective way.  Petco commented, ‘Despite a 27% growth in stores since 2008 – from 870 to 1,100 – our transportation spend on a cost-per-delivery basis has remained relatively flat. If you had told me we could add that many stores without raising the transportation costs, I wouldn’t have believed you.’”

The above excerpt talking about pet shop Petco highlights one of the important real-world cost concept in doing business: cost-per-delivery or in general, cost-per-activity. Many Asian entrepreneurs whom we have talked to over the past decade plus had lamented their problems in scaling up their business to get a decent valuation beyond the billion-dollar market capitalization barrier. They mentioned how sales might perhaps tripled in five or ten years, but core business profit growth (excluding deal-making trading profits) might remain flat or even decline, and a key reason (from a simple cost perspective) is that Selling, General and Administrative (SG&A) cost, thought by many to be a “fixed” or at least a “semi-fixed” cost, had increased even faster than sales. Rather than SG&A costs being fixed or even variable, these costs had become “super-variable” – increasing faster than sales.

The impatient entrepreneurs seeking their payday resorted to opportunistically manipulating this SG&A cost to improve dramatically their profit margin in the eyes of investors by shifting or deferring this expense item into the balance sheet items that include “Accrued Expenses”, “Other Current Liabilities”, “Other Non-Current Liabilities”, “Deferred Tax Liabilities” and so on, giving the excuse that these expenditures provide long-term payoffs which are unlikely to materialize and hence they should be expensed off. We classify and sum these up as “Other Payables”. A closer examination into the footnote disclosure would reveal these include loans due to directors, amount due to related-parties.

A common IPO fraud ruse by the insiders and investment bankers is for the directors to first borrow some short-term financing from the banks, using part of the borrowed money to create set-up customers to engage in fictitious sales with the IPO company. Once the IPO proceeds are raised, the loans to directors and amount due to related parties are repaid with other people’s money (OPM) – often disguised as under the purpose of “IPO proceeds used for working capital purposes”.

Another is to use the IPO company to buy equipment, goods and services at inflated value from their related companies. Equipment worth $20m is invoiced to the IPO company at $100m from the related company, with the insiders pocketing the “free” $80m profit which they either pump back to the company to boost artificial sales or to convert as “personal” investment into “free” equity into the IPO company in a show of “ownership commitment” in the eyes of the unsuspecting investors. This is often disguised as under the purpose of “IPO proceeds used for PPE, factory expansion and capex investments”. In the case of the accounting tunneling fraud through PPE and capex (we coined it as “Grand Capex Fraud” in our earlier articles), we will elaborate upon this in another future article.

As for deferred tax liabilities, joint-controlled entities and associates…

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In addition, the OP/OL ratio = Other Payables (OP)/ Operating Liabilities (OL) (Measure #6), a ratio in which we have observed that crossing over the unusually high 40% (as opposed to under 20% for the typical companies) leads to subsequent and future acts of accounting tunneling fraud in which corporate wealth and cash is tunneled out. In the case of Fuxing Zipper, the OP/OL ratio in 2007 and 2008 is 44% and 52% respectively, as opposed to around 19% for YKK for instance.

<ARTICLE SNIPPED>

In the case of Fuxing, let’s apply the below measures to detect the accounting transgression ahead of the curve before FY09-12:

• Bloated Balance Sheet (Measure #2)
• Measure #3
• Measure #4
• Measure #5
• Measure #6

 <ARTICLE SNIPPED>

 … the set of tunneling measures reveal that lurking beneath the deceptively attractive financial ratios and valuation metrics is the hideous Picture of Dorian Gray with all the sins hidden.

This is what we wrote in Aug 28, 2013 and we still feel very strongly, if not more so, about what we have written since:

“This prevalent situation in Asia is analogous to that of the Picture of Dorian Gray in the novel by Oscar Wilde (1890) – the face of Dorian Gray showed no signs of aging as time passed, whereas the sins of his worldly existence are vivid in the portrait of himself that he kept hidden in the attic. The Dorian Grays of Asia have been able to get away with their accounting frauds and misgovernance transgressions because they are branded as sexy growth companies who charm party-goers with their good looks (quantitative financials) and riding on “The Asian Growth Story”. 

At Bamboo Innovator, our task is to support fellow value investors to understand and appreciate the early signs of potential problems and red flags in Asian companies ahead of the market, to see the real attic portrait of the companies’ financial health and economic worth.

 We still hold on feverishly to the idealistic hope that a community of like-minded people can come together to spread their knowledge and kindness built around a resilient mental model, a home that everyone can breathe in it and make it their own. We hope that our candid and authentic views about value investing can be shared in our little community. 

 Thus, despite self-doubts all the time, this mission to create value for our readers with the Bamboo Innovator analytical framework has pulled us forward to devote nights after nights and squeeze every ounce of our bludgeoned body to do this. This is why we care so much about doing The Moat Report Asia for you.

 Having the inner compass of the Bamboo Innovator in our hearts can help us not lose our way in difficult and uncertain times as we journey together in the dangerous Asian capital jungles.”

Warm regards,

KB

The Moat Report Asia

www.moatreport.com

http://accountancy.smu.edu.sg/faculty/profile/108141/KEE-Koon-Boon

A new monthly issue of The Moat Report Asia is now available!

Access the in-depth idea presentation:

http://www.moatreport.com/members/

Paid subscribers get:

• The Monthly Moat Report Asia (20 issues)
• Bonus Content: The Weekly Bamboo Innovator Insight Articles (>70 Issues)
• Bonus Content: Access to the Members’ Forum
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• Our paid Members from North America, Europe, the Oceania and Asia include professional value investors with over $20 billion in asset under management in equities, some of the world’s biggest secretive global hedge fund giants, and savvy private individual investors who are lifelong learners in the art of value investing.

Part 2: Gandhi’s Talisman to Detect Accounting Fraud

Part 1: Are You a “First-Class Noticer” of Wide-Moat Compounders?

“Are you free now?” N asked me in a pensive mood when our paths crossed in a chance encounter in the underground basement of the Singapore Management University.

“Sure, what’s on your mind?”

“I have read your email on ‘To what can I devote my life’ last night and I have been thinking. I like to show you something. It’s an app business that I am doing up with my friend Chris.”

N, a SMU accounting student taking the course Accounting Fraud in Asia, and his friend Chris have started a mobile app company which had developed an Uber-like mobile app to assist us to beat the long queues in healthcare clinics.

M3 Inc (TSE: 2413)  – Stock Price Performance 2004-2015

When I listened to N explaining his app, i immediately shared with him the Japanese innovator M3 Inc (2413 JP, MV $6.6bn). M3 is an overlooked wide-moat Bamboo Innovator I wrote about in 2012 and shared with the CEO and top management team of a listed tech company in a series of workshop “Uprising! With Bamboo Innovators: Business Model Innovations and TMT Industry Trends” conducted in Singapore, HK and Beijing in 2012/13. M3 has since tripled to $6.6 billion. M3’s popular iTicket (www.iticket.co.jp) internet and mobile service used by more than 500,000 members to make reservations at clinics and beat the long queues might have some relevance for N to articulate the business model to seek funding – and clarity in their own execution and scalability. Both Chris and N have never heard of M3.

I explained briefly to them that M3 started out like a Google for medical professionals, with its core MR-kun service used as a marketing tool by pharmaceutical companies to provide consistent, repeated delivery of information on products and diseases. MR-kun also provides a channel for companies to receive questions and feedback from doctors, strengthening company/doctor relations.

With support by Sony Corp subsidiary So-Net which retains a 49.8% stake in M3, Itaru Tanimura established M3 in 2000 when he was 35. Essentially, M3 recognized that the demand for eDetails is quite high for busy physicians who require timely information at their convenience, without the limitations imposed by their off-line MRs. Doctors spend the most time collecting information via the Internet. Conversely, pharmaceutical firms spend the majority of their budget on MR related costs – and Japanese pharmaceutical firms’ huge marketing cost of ¥1.2-1.5tr ($10-12.5bn) is not sustainable.

Pharmaceutical companies signed up for MR-kun pay a basic annual fee of ¥70 to ¥100 million ($0.58 to 0.83 million) per electronic “e-detailing message,” which is the online equivalent of a sales visit by a MR (medical representative) to a physician’s clinic. In the pharmaceutical industry a sales visit by an MR to a doctor’s clinic is called a detail. M3 also charges fees for the production of promotional content and receives fees for other services such as facilitating the exchange of messages between pharma company MRs and their physician clients.  The average of M3’s top five clients pays ¥860m ($7.2m) every year.

A dominant platform used by 80% of Japan’s physicians, MR-kun is rated by over 92% of its users who said its usage “deepened their knowledge of diseases”. With this intangible trust built up amongst the community of users, M3 is able to leverage this relationship with its members to develop new online tools. These include online tools in clinical trials to determine the feasibility of trials and help with patient recruitment, market research and survey panels, and online job search and career information site for member doctors and pharmacists. In China, M3’s membership for the healthcare professional portal site Medilive.cn topped one million members in August 2014 after just five years, covering roughly half of the physicians in China. M3 leveraged upon the media capacity of Medilive.cn to expand into “Messenger”, the Chinese version of MR-kun.

M3 even expanded from B2B to B2C by providing a range of services for consumers including AskDoctors.jp, a subscription service that gives patients a chance to ask doctors questions about their ailments, and iTicket.

M3’s Tanimura-san is what literary giant Saul Bellow would call a “first-class noticer”. Two entrepreneurs or value investors can study the same business model, watch the same video, or even take the same advice from a mentor, but the intensively-attentive and committed first-class noticer pick up critical details, opportunities and talents among noise that the other misses.

Building on Bellow’s term, Harvard’s business psychology expert Max Bazerman studied why some people notice and act on threats and opportunities while others do not. Bazerman identified three core challenges to being a first-class noticer: (1) Ambiguity, (2) Motivated blindness due to ego or vested self-interest, and (3) Conflict of interest with our desires influencing the way we interpret information, even when we are trying to be objective, and others that include the slippery slope and efforts of others to mislead us.

We develop noticing skills by acknowledging responsibility when things go wrong rather than blaming external forces beyond your control. Some character moves we can make to become first-class noticers:

• Develop the introspection and capacity for observation to discover just how you learn and then to get out and do it.
• Build in a process and attract people around you to challenge ambiguity, motivated blindness, and any conflict of interest to change you might have. Do it with intention. Intentionally establish a system to test your biases and comfortable assumptions.
• Have a growth mindset that makes reinvention of yourself a regular way of life. Notice the signs. Find a way to embrace them rather than avoid them. Be self-accountable. Do it now.

Above all, the first-class noticer notices better because he or she cared more about their long-term journey than the shot-term paycheck. The intensive attentiveness is applied to a Purpose with an authentic Voice and the ability to engage others in shared meaning and to be truly aware of what’s going on in the world from wide-ranging and diverse sources of information. In the immortal words of leadership guru Warren Bennis, “the first-class noticer integrates a purpose with noble aims”. The first-class noticer devotes himself or herself to the Purpose and idea larger than themselves, being watchful and thankful. The word “watchful” is a legacy from the Old Testament – or a proactive sitting on a city wall and keeping watch. Watchmen were the first ones to see attacking armies or traveling traders. They saw things before others saw them.

One of the world’s greatest and most inspiring first-class noticer and Bamboo Innovator is Kazuo Inamori. Born into poverty, Kazuo Inamori lost his family home at age 13 and almost died that same year after contracting tuberculosis. A religious neighbour handed him several Buddhist religious tracts, urging him to meditate on the meaning of life. As he meditated, his TB subsided. His reprieve left Inamori with the idea that he should strive for the betterment of humanity.

Carrying this value in his heart, Dr. Inamori built two world-class companies from scratch in the course of a generation – global advanced ceramics company Kyocera (6971 JP, MV $20.6bn) (founded in 1959) and Japan’s second largest telecommunications firm KDDI (9433 JP, MV $62.8bn) (established in 1984), with a combined market capitalization of over $80 billion and employing over 80,000 kindred spirits. Through his commitment to society, which include the creation of the Nobel-class Kyoto Prize which honors contributors in technology, science, arts and philosophy by his Inamori Foundation, Inamori-san, 83, carries the voice of entrepreneurship on a global scale as the “Entrepreneur for the World”, an award he was presented with during the World Entrepreneurship Forum in 2009.

As president of Seiwajyuku, a business leadership association dedicated to nurturing business owners and entrepreneurs, Inamori-san, ordained as a Buddhist monk at 65, offered this advice to entrepreneurs:

“If your goal is to be a rich and beautiful celebrity, or if you are not willing to sacrifice yourself for the world and other people, do not try to be an entrepreneur. Entrepreneurs have heavy responsibilities and must share the fruits of their labor with employees and shareholders. We must always have criteria in our hearts that can help us answer the question, ‘What is the right thing to do as a human being?’ and guide us to do what is good for society and humanity in our daily work.”

After our chance encounter, N sent me an email that he aspires to build the “M3 of Southeast Asia”: “Uber became the one of the largest transport service company with no taxis. Alibaba became the world’s largest e-commerce company with no inventories. We hope our company can have a firm foothold in the medical industry without clinics”.

The medical industry needs high reliability because of its mission to care for the life of human beings. This is the reason why M3 succeeded with the trusted platform, the “emptiness” of the trust and support from the community of pharmaceutical firms, physicians, and patients to generate stable and continued income with the option value and potential to expand their business based on the trusted platform.

We wish N all the best in the pursuit of his aspiration – and to become a first-class noticer of business model innovations beyond the mere technical aspects of what makes a wide-moat compounder.

Part 2: Gandhi’s Talisman to Detect Accounting Fraudx

The revered Indian leader Mahatma Gandhi once gave to his grandson Arun a talisman that listed the seven “blunders” that he believed led to violence:

Wealth without work.

Pleasure without conscience.

Knowledge without character.

Commerce without morality.

Science without humanity.

Religion without sacrifice.

Politics without principles.

Number four on the list – Commerce without morality – was poignant in accounting tunneling fraud that is increasingly prevalent in the Asian capital jungles akin to 2011. 2011 is the year when many Chinese stocks unravel in accounting frauds: Sino-Forest, Long-Top Financial, China Agri-Tech, ChinaCast Education etc. 2011 is the year of the shadow banking crisis rearing its ugly head, akin to the late 1990s, leading to a tightening in credit conditions, which in turn resulted in companies finding it more difficult to opportunistically use the roll-away “other receivables” and loan guarantee accounting tunneling trick with cheap money.

As we have explained in an earlier article “Shedding of the Asian Snake’s Skin: The Opportunistic Tunneling of Corporate Wealth”, loan guarantee presents a seemingly innocuous Opportunity to maliciously tunnel out corporate wealth in Asian companies.

Take the case of Olympus. It deposited ¥21bn in Japanese government bonds with LGT Bank and arranged for the bank to use these bonds as collateral for a loan to two shell companies, the “tobashi”. The unconsolidated shells in turn used the borrowed funds to buy the toxic investments from Olympus at the original cost. Olympus recorded the amount it deposited with LGT and the toxic assets were considered “sold” to the shells, thereby avoiding recognizing massive losses on these underwater securities. In other words, Olympus acted as a guarantor of loans made by the banks to the shells by depositing funds at the banks equal to the amount loaned. If the related-party nature of the transaction was disclosed, the ¥21bn will be recorded as a financial liability in the balance sheet.

In China and Asia, the loan guarantee accounting problem to undisclosed related parties has shifted to intercorporate loans, classified under “Other Receivables”. With some reforms mitigating these RPTs, the Asian Snake has adapted and shifted to other accounts in disguised forms. Hence our earlier article for a sense of urgency to develop a new composite measurement of accounting tunneling fraud. Hence, cash in the balance sheet in Asian companies is invariably never really cash unless one examines these related-party transactions (RPTs), often held in scant regard by investors using western-style financial statement analysis and by Asian auditors.

Note that when value investors tend to use quant screens and investment checklists, however rigorous, to churn out a list of investment targets with high cash & cash equivalents, the numbers and ratios such as EV/EBITDA, EV/EBIT, P/Book, ROIC, ROE, ROA, Net Operating Assets etc all use aggregate numbers that include these “other receivables/prepayments/cash equivalents etc” into the calculation – producing misleading and fatal interpretations. This is easily evident in recent weeks in which audit failures have erupted in a number of HK-listed Chinese companies that are “value stocks” with “cheap” PE and P/Book ratios or are former thematic stock darlings – and the telltale signs of the accounting tunneling fraud can be detected a few years before the actual accounting woe in what we have shared in our course Accounting Fraud in Asia taught at the Singapore Management University. These recent cases include:

China Taifeng Bedding (873 HK, MV $139m) on 31 Mar 2015, Auditor: Baker Tilly

The “cheap” value stock: PE 10.6x, P/BV 0.36x

Delay in the publication of 2014 Annual Results due to:

• Potential impairment in the fair value of the financial guarantee contracts given to banks on the borrowings of its subsidiary Shandong Taifeng Textile given to “independent third parties” (possible related-parties?).
• Likely impairment in the fair value of the estimation of the recoverable amounts of the Group’s assets, including other receivables and loans receivables of RMB480m.
• Auditors are unable to ascertain the cash flow position of the Company, including the liquidity position of the Company

Below is the interim 2013 report announced on Sep 12, 2013 when its share price was HK$1.55 (now HK$1.08). One can notice that the trade and other receivables and prepayments as at 30 Jun 2013 is RMB1.4bn and the corresponding footnote only discloses the trade receivables amount of RMB836m, totaling omitting the “other receivables and prepayments” of RMB568m. This amount is subsequently the source of the audit failure announced on 31 Mar 2015, a year and a half later. By FY2013, the amount of these “other receivables, prepayment to suppliers, prepayment for operating expenses, loan receivables” has exploded to RMB1bn!

Nature Home (2083 HK, MV $208m) on 26 Mar 2015, Auditor: KPMG

The “cheap” value stock: P/BV 0.5x

Sound Global (967 HK, MV $1.3bn) on 31 Mar 2015, Auditor: Deloitte

The “cheap” value stock: PE 13.6x, P/BV 2x

Rexlot (555 HK, MV $1.2bn) on 28 Mar 2015, Auditor: Ting Ho Kwan & Chan (THKC)

The “cheap” value stock: PE 7.5x, P/BV 1x

China Qinfa (866 HK, MV $67m) on 31 Mar 2015, Auditor: KPMG

The “cheap” value stock: P/BV 0.2x

<Article snipped>

As Gandhi points out with his wisdom, Commerce without Morality leads to Violence and Accounting Fraud.

Commerce would not have progress beyond the barter system without the invention of a system of weights and measures. Before there was the traditional Chinese steelyard (gancheng), buyers and sellers eye the heap of goods to determine their weight. It is difficult to achieve a fair trade. With the gancheng, the object to be weighed hangs at one end of the beam, while the weights at the other end are slided left or right until a perfect balance of the beam is found. Reading of the mark where the weight-string rests is made to determine the weight of the object. There are 16 markings on the arm of a gancheng, such that 16 qian is equivalent to 1 liang and 16 liang is equivalent to 1 jin (or 604.79 grams). The Chinese unit of measurement was based on the number 16 instead of 10.

But why 16?

16 is the sum of 7, 6 and 3. 7 stands for the Beidou Seven-Star Constellation, which symbolizes the need to have the right direction in our heart when we use the measurement tool to make money and not be too greedy. 6 stands for the directions North, South, East, West, Up, and Down, which cautions us to stay centered in our ethical principles when making money. Lastly, 3 stands for Fu (Good Fortune), Lu (Prosperity), Shou (Longevity). When we make money by squeezing one liang improperly out of others, we lose Shou (Longevity); wrench two liang and we lose Lu (Prosperity). Give money back to the customers and society in a sustainable way and we gain Fu, Lu, Shou. Thus, the 16-unit scale is not merely a tool to measure and make money, but more importantly, it is a scale to guide and measure our values in life and in business.

To rephrase Gandhi’s talisman, commerce is not merely about the measurement of the weight of profits collected in multiple clever transactions to build abstract personal wealth. Only in the endeavor to perform first for customers, and serve them with the highest possible integrity and character, can commerce find its foundation for durable business success and create society’s abundance.

PS1: We will be speaking again at the Asian Investing Summit on April 7-8, joined by First Eagle’s legend Jean-Marie Eveillard, Third Avenue’s Amit Wadhwaney, Japan’s HC Capital’s Noriyuki Morimoto-san, Varecs Partners’ Jiro Yasu, and other value investors: http://www.valueconferences.com/reg/asia15/

PS2: This is a double-issue for April 6 and April 13. We will be back with the weekly on April 20. In the meantime, we will be uploading value-added content such as potential accounting fraud reports that include Rexlot and actual accounting fraud cases such as Malaysia’s Transmile for our Moat Report Asia paid subscribers.

Warm regards,

KB

The Moat Report Asia

www.moatreport.com

http://accountancy.smu.edu.sg/faculty/profile/108141/KEE-Koon-Boon

A new monthly issue of The Moat Report Asia is now available!

Access the in-depth idea presentation:

http://www.moatreport.com/members/

Subscribers get:

(1)    The Monthly Moat Report Asia (20 issues)

(2)    The Weekly Bamboo Innovator Insight Articles (>70 Issues)

(3)    Access to the Members’ Forum

(4)    Videos and Presentations by Thoughts Leaders, Entrepreneurs and Business Leaders in Asia

(5)    Asian Extractor – Unearthing Accounting Fraud in Asia. Any potential new value-added content about Asia’s accounting fraud risks and governance pitfalls from the course will be shared with our Subscribers as we journey together in the miasmic Asian capital jungles. We are pleased to present the presentation materials exclusively for our Moat Report Asia subscribers:

• Week 1 – Survival in the Asian Capital Jungle: Who Knows What When? (108 slides)
• Week 2 – Western Tools to Catch An Asian Snake? (111 slides)
• Week 3 – The Incentivized Asian “Wedge” Snake to Tunnel Corporate Wealth (105 slides)
• Week 4-5 – Shedding of the Asian Snake’s Skin, The Opportunistic Tunneling of Corporate Wealth (157 slides)
• Week 6 – Descend into the Asian Snake’s Lair, Occult Offshore Centers, Tax-Tunneling, and Consolidation Craftiness (89 slides)
• Week 7-9 – The Asian Snake Charmer and Stock Manipulation Scheme  (112 slides)
• Week 10 – The Accounting of Words and the Hiss of the Asian Snake (57 slides)

You will also get download access to the presentation by our invited expert guest speakers:

• Mr. Jarrod Baker, the Senior Managing Director at NYSE-listed forensic specialist FTI Consulting Inc (NYSE: FCN, MV $1.5bn).
• Mr. Hemant Amin, Founder, Chairman and CEO of Asiamin Capital, a successful multi-million single family office, and Founder and Chairman of the BRKets investor group (www.brkets.com)

(6)    Emerging Markets Research. KB is also the co-advisor to the School of Accountancy’s SMU Emerging Markets Club (www.smuem.com). Carefully-curated presentations are made available for download for our subscribers:

• Kerry Logistics Network (636 HK) and China’s Transportation & Logistics Industry, by JIANG Lingjun
• PT Bank Tabungan (BTPN IJ): BTPN’s Successful Business Model, by Daniel IGOR
• PT Sumber Alfaria Trijaya Tbk (Alfamart) (AMRT IJ): Maintaining Its Stranglehold as Competition Heats Up in Indonesia’s Modern Grocery Retail Industry, by Kelly GOH Wan Jun
• Mitra Adi Perkasa Tbk PT (MAPI IJ): Still Fashionable in the Fashion Apparel Retail Industry? by Lucas LIM
• Alibaba: Embracing Its Challenges + China Online Market: Growing with Challenges, by JIANG Lingjun
• Ulmart: Russia’s Own Amazon, by Christina LIM

• The weekly insight is a teaser into the opportunities – and pitfalls! – in the Asian capital jungles.
• Get The Moat Report Asia – a monthly in-depth presentation report of around 30-40 pages covering the business model of the company, why it has a wide moat and why the moat may continue to widen, a special section on “Inside the Leader’s Mind” to understand their thinking process in building up the business, the context – why now (certain corporate or industry events or groundbreaking news), valuations (why it can compound 2-3x in the next 5 years), potential risks and how it is part of the systematic process in the Bamboo Innovator Index of 200+ companies out of 15,000+ in the Asia ex-Japan universe.
• Our paid Members from North America, Europe, the Oceania and Asia include professional value investors with over $20 billion in asset under management in equities, some of the world’s biggest secretive global hedge fund giants, and savvy private individual investors who are lifelong learners in the art of value investing.

When a group of the very best leaders were asked by the Wall Street Journal in 1999 to pick the most influential invention of the millennium, the late Mr. Lee Kuan Yew alone shunned the printing press, electricity, the internal combustion engine and the internet and chose something odd: the air-conditioner. He explained that, before air-con, people living in the tropics were at a disadvantage because the heat and humidity damaged the quality of their work. Now, they “need no longer lag behind”. LKY was obsessed with productivity and driven to do his best in crafting his own greatest invention in Singapore.

More than 25 years ago, there was an Asian company who was producing and selling air-conditioner with a productivity level that would have made LKY proud. And they were so good that the Japanese manufacturers got worried and tried lobbying to impose anti-dumping duties on the company’s imports into Japan. That didn’t work. Then the Japanese got clever, really clever. They drastically restricted the number of the most important Component X in the air-conditioner shipped to the company’s country. Overnight, the company’s impressive productivity machinery grinds to a halt.

In the words of Mr. C, the chairman of the company: “That was when we realized deeply that if we lack the heart of the aircon, the X, the heart of technology, having sales orders is pointless since production cannot take place. That was when we decided to undertake the task of having control over the technological know-how in X and the new spinoff company was established with the vision of technical independence. Only with technical independence can you build for the long-term.”

Our latest monthly Moat Report Asia for April 2015 examines an Asian company that is the world’s #4 air-conditioner X manufacturer with 10% market share, up from 3.5% in 2000. Regionally, the company is #1 in its domestic market with 39% share, 30% in North America, 12% in Europe, 9% in Japan, 13% in South America. The company also has niche dominance in X for the recreational vehicle (RV) market in North America with 60% market share and over 90% market share in a new application in X (“Y”) for a niche household appliance in Europe in partnership with Bosch. The company’s annual X capacity is 15m units and has plans to expand by 6m units to 21m units in 2H15. The company has a diversified customer base that include Carrier-United Technologies, Goodman-Daikin, Bosch, Electrolux, Miele, Haier, TCL, Midea, Sharp, Sanyo,. The company’s strategic shareholders include a Japanese electronics giant with equity stake of 4.86%.

What makes It a wide-moat business? We are impressed with its advanced production and technological know-how: (1) Grinding: The company has developed deep intangible know-how in grinding technology for X, in which metals need to be ground to micrometer-level precision, thinner than a human hair. The company is able to achieve exceptional production efficiency of 68 ppm i.e. out of every 1 million units, only 68 are rejected, possibly the best quality standard in the industry. (2) Inverter controller: It is not possible to create an energy-saving air conditioner with satisfactory performance by attaching an inverter procured from an electronics parts maker to a conventional air conditioner. Making an energy-saving air conditioner requires knowledge that cannot be easily imitated, such as the ideal number of motor revolutions under certain operating conditions. Sophisticated control technologies are required to optimally control the temperature in multiple rooms with multi-split air conditioners.

Above all, the company has superior R&D capabilities to leverage upon technology and know-how to enter into new higher-margin business, including adopting the open innovation business model to co-develop new products with external strategic partners. As a result, the company’s gross margin has risen from 12.97% in 2010 to 16.5% in 2013. These new businesses have promising market potential and scalability, including (1) higher-spec air-conditioner X for recreational vehicles (RV) in which the company has 60% market share in North America; (2) “Y” co-developed with Germany’s Bosch in which the company has >90% market share in Europe, and potential new customers in dish-dryer; (3) “Y” for commercial and residential applications; (4) breaking the Japanese dominance in high efficiency Brushless Direct Current (BLDC) motor product, (5) air-purifier in partnership with Sharp, (6) mini-X in portable fire extinguisher, mini-dehumidifier, portable aircon. Management shared that they have mid-to-long-term plans to develop BLDC motors for vehicles, DC inverter controller and high-end X for medical applications.

The company pursued a vertical integration strategy and has the capability and know-how to make everything in-house at present, resulting in one of the most efficient working capital cycle in the industry. As the global #4 X manufacturer making 15m units, or one out of ten X in the world, the company has built formidable competitive advantages in scale and product quality, and it has bold plans to expand capacity to 21m units. Profit margin is likely to climb further as it extends its dominant market leadership in the higher-margin niche segments of North American recreational vehicle (RV) market with 60% market share, European “Y” market with over 90% market share and break into new applications and market segments and new applications in air purifiers in China in partnership with Sharp. The company’s short-term downside is protected by an attractive 6.37% dividend yield.

The company has a visible long runway as it broke the long-time dominance of the Japanese in the multi-billion energy-efficient Brushless DC (BLDC) motor market with initial output of 1.5m units (ASP $10-11/unit) in Jan 2015 and a new plant with initial output of 3-5m units in 2H15 with potential to scale up capacity to a total of 24m units. Valuation is also decent and reasonably cheap for a world-class company with PE 12.6x, EV/EBIT 10.6x and EV/EBITDA 7.1x. Net profit and EBITDA could potentially double to $70m and $150m respectively in the next 5 years in FY2020, pointing towards a 280% growth in market value to $1.8bn based on a modest EV/EBITDA 12x.

Despite being not profitable for as long as the first ten years since it was established in 1989 due to the lack of production scale, the company persisted in pursuing the aspiration of achieving technical independence in the heart of the air-conditioner technology – the X – under the leadership of its chairman Mr. C. Led by Chairman C and CEO L, the company showed grit and determination in breaking past the milestone of an accumulative 100m units in 2014 and has plans to produce and sell another 100m units by 2020/21. We think the perseverance and focus is rare in Asian firms and the company deserves a valuation premium.

Q: “Chairman C, we admire your persistence and determination that resulted in [company’s name]’s success as the global #4 air-conditioner X company. What kept you going all these years? And how do you pass on your values to the corporate culture and your employees at [company’s name]?”

Mr. C: “In life, we must have dreams and aspirations. With dreams, our life becomes beautiful. An enterprise must pursue its dreams too. Our initial dream was to have technical independence and to produce world-class products. We are now #4 in the world and aiming at overtaking #3 in the next five years. Above all, [company’s name] aims to pursue the dream of creating infinite possibilities in smart, innovative energy-saving and environmentally-friendly future with ‘[Company’s name] Inside’, like ‘Intel Inside’, for multiple products and applications because of our superior quality and innovation.

The corporate culture is that all of us at [company’s name] must adjust rapidly to the changing world. Attitudes, morals and thinking are the starting point of thoughts. Only by allowing our attitude to change our habits, habit to change character and character to change life and maintain a positive outlook on life can the ‘responsibility, integrity, innovation’ values fill employees and grow with the company. Anyone with responsibility, motivation and ambition can help [Company’s name] to create a new chapter in history and keep rewriting it.”

Who is Mr. C and this wide-moat Bamboo Innovator?

PS: In remembrance of the late Mr. Lee Kuan Yew, modern Singapore’s founding father, we like to share an article series that we wrote five years ago about Berkshire Hathaway and Singapore, both wide-moat compounders created and built by visionary leaders.

Part 1: The power of vision

The success of Berkshire Hathaway and Singapore can be traced to their visionary leaders who work with winning teams

http://www.smu.edu.sg/sites/default/files/smu/news_room/smu_in_the_news/2010/sources/LHZB_20100809_2.pdf

Part 2: Lion Infrastructure and value investing

Both of them are an ongoing team process that demands sacrifice, hard work and soberness to scale new heights

http://www.businesstimes.com.sg/?dlink=/sub/views/story/0,4574,389848,00.html

Part 3: Lion Infrastructure is the way to go

To reach a US$2 trillion GDP in 2065, Singapore must create and build commercial assets with a special quality

http://www.smu.edu.sg/sites/default/files/smu/news_room/smu_in_the_news/2010/sources/BT_20101230_1.pdf

The Trilogy in One Document:

http://www.slideshare.net/KeeKoonBoon/lion-trilogy-lion-entrepreneurs-and-lion-infrastructure-media-articles

Warm regards,

KB

The Moat Report Asia

www.moatreport.com

http://accountancy.smu.edu.sg/faculty/profile/108141/KEE-Koon-Boon

A new monthly issue of The Moat Report Asia is now available!

Access the in-depth idea presentation:

http://www.moatreport.com/members/

Paid subscribers get:

• The Monthly Moat Report Asia (20 issues)
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At the admission interview of the high school applicants into the Accountancy program at the Singapore Management University last week, one of the  candidates “C” cried during the interview – and I gave her the highest score 19/20 amongst all the candidates and wrote down “strongly recommend”.

We like to share some of the conversations in this story which inspired the discussion about why for instance Singapore’s Creative Technology (CREAF SP, MV $74m) did not scale up to become the Apple of Singapore/Asia, collapsing from over a billion dollar in market value at its peak to $74 million today, as well as the deeper thought-provoking insights to understand and identify the hidden Asian innovators that include Loen Entertainment (016170 KS, MV $1.09bn) which had more than tripled since we last highlighted them in Aug 2013 in “Berkshire Hathaway Embracing Media? An Asian Perspective”.

“C” did not have the straight-As profile (H2: AABD, H1: AC) and even had a “poor” General Paper score, which was strange given her vivid and heart-stirring writing in the application form describing herself and the various activities she does that contributed to helping others during her time at Hwa Chong Junior College. The first impression she would definitely give to others would be that of a stereotypical shy, self-conscious and introverted person. A checklist approach and mindset will definitely strike “C” out.

I sense that there is brilliance beneath her shyness as some of my probing questions and observations revealed that she is an introspective, self-reflective and intellectually curious thinker and tinkerer capable of something rare that eludes the straight-As and well-rounded-CV students – to produce original thoughts and ideas. “C” is the only candidate that I have come across in these years to have applied for both the Accountancy and Information Systems degree programs. With her interests in the Science Students’ Research Council where she was in the International Science Youth Forum Nobel Forum Committee, it seems that she has a yearning to do and make something with her hands and brains, that she is a tinkerer, and a tinkerer who is keen to explore further her interest and confidence in “numbers” – and to peer into the “framework” behind the “numbers”.

“C, I see that you are capable of deep thoughts. I think your General Paper score was because you are too self-conscious in your thoughts about how you come across to others, that you are afraid of being misunderstood in the eyes of others and that affected your writing in that time constraint and pressure in the exam setting. Are you able to share what is the proudest piece of work that you have done up, beyond all these society-imposed resume criteria to fill the CCAs/Community Service silos?” This is akin to asking what does a person do if he or she is not measured by the KPIs or observed by others – to understand their true character and authenticity as a leader and innovator.

And “C” shared about her “The Physics and Science of Music” piece of project work and prototype that I find very interesting and aligned to her deep-thinker personality and untapped hidden potential as an innovator, a Maker who has the capacity and capability to engage in creative work and systems design, work which requires deep thoughts, tenacity and sacrifices to bear through the uncertainty, anguish and passions. The usual self-entitled Taker with straight-As will hardly bother with such meaningless pursuits that do not have deterministic and measurable outcomes. Under all those society-imposed boxes, “C” could not mention or write about this at all in the form.

Instead, “C” said wistfully, “But this is probably not worth mentioning. There is no value to this. It probably cannot be commercialized.”

Inspired by her sharing, I said, “Why not? Imagine if Creative Technology had focused on your idea and organizing vision in the science of music, the science of audio and sound, they probably would not have languished.”

I explained very briefly to “C” that Creative Technology had brought to the world in 1989 the Sound Blaster, a stereo soundboard inserted into the computers to give the computer a voice to play music. And this technology was made widely available to the general consumer, bringing what was previously accessible only to the privileged and wealthy to the masses to enjoy. Creative became the first Singapore firm to be listed on the NASDAQ stock exchange and Sim Wong Hoo, the harmonica-playing founder of Creative, became the youngest self-made billionaire in Singapore at the age of 45.

********

When Creative’s founder Sim Wong Hoo was said to seek some government financial assistance at the NCB (National Computer Board, now known as IDA) to market the product at Comdex trade show in US, they ridiculed him, saying that no one would ever want to hear a sound from the PC. They rubbed salt in by mentioning that he was just a poly diploma holder and that he needs to develop something for the local market for which NCB would give him assistance. Later, funded by a venture capitalist, Sim showcased Sound Blaster in the exhibition in America and, according to some photos, even Michael Jackson visited his booth. Sim later said about his vision, “I looked at the PC and said it was dumb. I said computers should talk. Computers should play music. I believe in sound. I believe in music.”

Creative dominated the PC audio market as the de facto standard for a decade and had sold 100 million units by 2000. The all-time high was in March 2000 at $64 per share; now Creative is $. By the 2000s, OEM PCs began to be built with sound boards integrated directly onto the motherboard and the Sound Blaster found itself reduced to a niche product. Creative went on to launch other less successful businesses and products that include the CD-ROM business in which they were forced to write off $100 million in inventory when the market collapsed due to a flood of cheaper alternative, Nomad Jukebox and ZEN series of portable media players (before Apple launched iPods), Prodikeys (a keyboard with piano keys), reportedly burning a billion dollar in R&D in developing both the Zii stem-cell-like processor with supercomputing power launched in 2009 and the HanZpad computer tablet launched in late 2011.

After sharing the Creative story to “C”, I was thinking that Creative could well have been the innovator in Guitar Hero, the billion-dollar gaming franchise that rekindle music education in children and has found use in health and treatment of recovering patients. Creative could also possibly ride the rising popularity and profitability of podcast network and audio storytelling phenomenon (podcast subscriptions have passed over one billion in 2013 and monthly podcast listeners have more than tripled to over 75 million per month from 25 million before the onset of the 2007 crisis). Creative could possibly beat Pandora Media (P US, MV $3.4bn)/Spotify/Deezer/Beats Music (acquired by Apple); the Pandora music-streaming app are embedded by GM into the dashboards of most Chevrolets, Buicks and Cadillacs.

Taiwan’s KKBox, started in late 2005 as a PC application, now has over 2 million paying subscribers paying a monthly fee of around $5 for unlimited access to its catalogue of more than 10 million Asian songs and value-added content and services and is valued at over a billion dollar, attracting a $105m investment from Singapore’s GIC in 2014. KKBox has a dominant position in Taiwan in knowing where the music listeners are and what songs and artists they like and now offers a mixture of music, entertainment news, and even organizes its own concerts that are broadcast across the countries they are operating in.

Loen Entertainment (016170 KS, market cap $1.09bn) operates Korea’s largest online music retail platform MelOn with a 60% market share. Loen was founded in 1961 by former English-language-daily journalist Min Young-bin as YBM Sisa English, a language-learning tape creator. In the 1960s when Korea was an impoverished nation just out of war, the medium of studying English was limited to printed publications including magazines, books and dictionaries. YB Min launched the country’s first magazine for English learners in 1961 and “A Handbook of Business English” in 1967 in response to policies designed to drive exports. The next decade marked the use of audio and sound in language education. In 1970, supported by the U.S. government, YBM brought out English 900, a set of six books with 60 cassette tapes on 900 English sentence structures. YBM later expanded into a major K-Pop music record label which debuted hallyu celebrity Rain. SK Telecom bought a 60% stake in the music record firm in 2005, renaming it Loen to be put in charge of operating SK’s online music distribution service MelOn in 2009. With the cataloguing know-how developed over the years, MelOn grew to become the most used online music sales in Korea. SK later sold its 52.6% stake in Loen to a foreign PE firm for $239m in Jul 2013.

Organized by the science of music, an idea larger than oneself, the possibilities from business model innovation are more scalable and sustainable, instead of jumping around in chasing trends and themes like Creative did in repeating familiar hardware-based business models that had worked successfully for a while in the past but failed subsequently to remain sustainable.

********

Because I sense that her community service work is based on a genuine heart, which is rare, I asked “C” gently whether that was shaped by some personal or family experience and she said something moving and aspirational, which was not discernible at all in her opening introduction and write-up.

People like “C” will always be misunderstood, and misunderstood badly, because the harsh and pretentious world look solely at the superficial skin, the poise, the posturing and never the inner worth and potential. “C” is the potential innovator and authentic caring leader who can contribute to improving the world and the people around her and she has far bigger potential that she realizes and that hidden potential needs to be unlocked with an opportunity.

In our years of interacting and observing entrepreneurs and managers in Asia, we find that there seemed to be two kinds: some who would look for flaws in ideas and people, and then pounce to kill them; and others who started from a place of seeking and promoting good, new and original ideas and people. When the “idea and people promoter” saw flaws, they pointed them out gently, in the spirit of improving them – not eviscerating them. The “idea and people killer” were not aware that they were serving some other agenda, which was often to show others how high their standards are. The innovators understand the difficult, ephemeral process of developing the new. The innovators understand that looking beyond the pretty and rigorous checklist for something original, authentic, something surprising and unproven, are necessary for genuine value creation – and must be a conscious effort.

We also want to observe that the corporate culture are NOT infested with the kind of people that populated Disney in the late 1970s as remarked by Pixar’s founder Ed Catmull in his inspiring and thought-provoking book Creativity, Inc.: Overcoming the Unseen Forces That Stand in the Way of True Inspiration:

“Unbeknownst to me, soon after our meeting at Lucasfilm, John Lasseter would lose his job at Disney. Apparently, his supervisors felt that The Brave Little Toaster was – like him – a little too avant-garde. They listened to his pitch and, immediately afterward, fired him. What John hadn’t realized when he joined Disney Animation, however, was that the studio was going through a rough, fallow period. The animation there had plateaued much earlier – no significant technical advances had been made since 1961’s 101 Dalmatians, and many of its young, talented animators had left the studio, reacting in part to an increasingly hierarchical culture that didn’t value their ideas. When John arrived in 1979, Frank Thomas, Ollie Johnston, and the rest of the Nine Old Men were getting up in years – the youngest was 65 – and had stepped away from day-to-day business of moviemaking, leaving the studio in the hands of a group of lesser artists who had been waiting in the wings for decades. These men felt in was their turn to be in charge but were so insecure about their standing within the company that they clung to their newfound status by stifling – not encouraging – younger talents. Not only were they not interested in the ideas of their fledgling animators, they exercised a sort of punitive power. They were seemingly determined that those beneath them not rise in the ranks any faster than they already had.”

We think this lesson from Disney is poignant for Asia which is at a critical transition phase in succession risk (and opportunity) with the patriarchs and matriarchs handing over the reins of their business empires to the right capital allocators, whether to their heirs or professional managers. Many of the Asian successors are like Disney’s highly experienced and well-qualified men-in-charge in the late 1970s.

Above all, we think a corporate culture focused on KPIs is downright unhealthy as it results in gaming of the performance measurement system and distances people from creating an idea larger than oneself that can involve co-creators in the value creation process. What is this “idea larger than oneself” which we emphasized in many of our writings? Take the case of Hemant Amin, founder, chairman and CEO of Asiamin Capital, a low-profile, successful multi-million single family office, and our guest speaker for the Singapore Management University students in the course ACCT004 Accounting Fraud in Asia with the presentation topic “A Family Office Investment Journey and Understanding the DNA of Fraudulent Promoters”. We mentioned in a thank you note to Hemant that this idea larger than oneself is also about practicing and living out the values of Buffett-Munger:

Hi Hemant,

Thanks much – a recurring theme in the Compounders is that they are obsessed with creating an idea larger than themselves, whether it is Buffett-Munger with their philosophy manifested in their creation of Berkshire Hathaway or yourself in practicing and living out the values of a true value investor to educate and inspire the next generation of leaders! 🙂

Take the case of Lee Bakunin, a very early Berkshire Hathaway value investor whom we respect and admire greatly. A lawyer by training, Lee is the author of the upcoming book “How to Negotiate Like Warren Buffett”. The book’s vision is an idea larger than oneself. With the book, Lee has transcended beyond material wealth. He can remove himself from the equation and the ideas in the book will profoundly influence and impact positively the readers. Those who practice the philosophy in the book will become the idea itself. We hope to be able to have the opportunity in the future to invite Lee to address the SMU students taking the course Accounting Fraud in Asia and to inspire them with his wisdom and values.

Hence, value investors should simply ask, can the Asian entrepreneur-emperor remove himself or herself from the business equation and the business can still compound in value? Only if he or she has created an idea larger than oneself. This is the true and only KPI that should matter in identifying the wide-moat compounder and Bamboo Innovator in Asia.

And “C”s question to me at the end of the interview was also simple and brilliant, again reflecting her deep-introspective character. Having done admission interviews before, this was the first time I was asked such a question.

“C, you are very good, don’t let anyone tell you anything otherwise,” I told her at the end. I think she cried softly two times during the interview because she felt she was understood, that her inner self was understood, that what she was trying to achieve at an emotional level was understood.

“C” would still need to go through the admissions office’s elimination process based on the number of available places and we hope that she can get into SMU and the program(s) of her choice. We wish her all the best in creating the music of accounting for the business community and society in the years ahead.

Warm regards,

KB

The Moat Report Asia

www.moatreport.com

http://accountancy.smu.edu.sg/faculty/profile/108141/KEE-Koon-Boon

A new monthly issue of The Moat Report Asia is now available!

Access the in-depth idea presentation:

http://www.moatreport.com/members/

•  The weekly insight is a teaser into the opportunities – and pitfalls! – in the Asian capital jungles.
• Get The Moat Report Asia – a monthly in-depth presentation report of around 30-40 pages covering the business model of the company, why it has a wide moat and why the moat may continue to widen, a special section on “Inside the Leader’s Mind” to understand their thinking process in building up the business, the context – why now (certain corporate or industry events or groundbreaking news), valuations (why it can compound 2-3x in the next 5 years), potential risks and how it is part of the systematic process in the Bamboo Innovator Index of 200+ companies out of 15,000+ in the Asia ex-Japan universe.
• Our paid Members from North America, Europe, the Oceania and Asia include professional value investors with over $20 billion in asset under management in equities, some of the world’s biggest secretive global hedge fund giants, and savvy private individual investors who are lifelong learners in the art of value investing.

After witnessing over the decade plus how the Asian capital jungle has turned increasingly into a fertile ground for insiders-promoters-syndicates who have the incentive and power to manipulate prices and volumes, to deceive investors with fraudulent financial numbers, and to inject market “action” via positive corporate announcements of various sorts to excite the senses but rarely materializing subsequently  in economic substance, luring investors and their funds in and then offloading the shares a pump-and-dump stock manipulation scheme, I desperately and madly wanted the SMU students to learn from a rare positive role model in the Asian capital jungle – and Hemant’s name is at the top of my list to invite as a guest speaker to inspire the students.

Hemant showed that it is still possible to win as a value investor because of one having not only the right investing approach but more importantly, having the right values in life. That it is possible to create value without compromising on values in this harsh, pretentious and messy world. That one can avoid investing in the fraudulent promoters by understanding their DNA.

It is immediately obvious that only someone who has a deep thinking process and value system can craft out such thought-provoking insights. Hemant’s carefully-prepared presentation material reflects and exudes his deep introspection, knowledge, resilient investment process and values. Having weathered through adversities and the mental drain in fighting the fraudulent promoters to reclaim the money invested, Hemant’s investment journey took a life-changing turn when he attended Berkshire Hathaway’s AGM in 1997 for the first time – and Hemant has made the pilgrimage to Omaha every year since. Hemant started to focus on the quality of the management and the business model and understood the difference between statistically-cheap cigar butts generated from net-net screens and checklists made famous by Benjamin Graham vs compounders which was the focus of Charlie Munger, the Vice-Chairman of Berkshire Hathaway and the influential partner to Buffett’s success.

Because Hemant’s presentation is so good, I have invited the team of economic crime prosecutors at AGC (Attorney’s General Chambers) Financial & Securities Crime Division who might be coming over for the presentation. The AGC has recently invited me for a talk session on accounting and securities fraud in Asia with their DPPs; it is a great honor and I wish to share with them Hemant’s great insights.

It will be great if you wish to join us on 17 March (Tuesday) at 4.30pm till 7pm.

Warm regards,

KB

The Moat Report Asia

www.moatreport.com

http://accountancy.smu.edu.sg/faculty/profile/108141/KEE-Koon-Boon

PS: We are honored that Hemant is a fellow Moat Report Asia subscriber. We will be making Hemant’s presentation material available for our Moat Report Asia subscribers.

Part 2: Mocking Asia, the Pixar Solution and the R.E.S.-ilence Handle

“If we were to mock Singapore, we would say it is a nation of bankers and real-estate developers. What we would like to become is a nation of entrepreneurs. The country is missing a big trick about how it thinks about entrepreneurial thinking. We make a list of all the things we want to do and we say okay, check, we’ve done that. It’s a list-building mentality. It’s not an opportunity-framing mentality – which is what entrepreneurial thinking is about… You cannot beat Apple by becoming more like Apple… We have to embrace being Asian… We have to build something uniquely Asian.”

– Singapore Management University (SMU) business dean Gerard George in “Thinking Beyond the Checklist”, 13 March 2015

“But my internal sense of purpose – the thing that had led me to sleep on the floor of the computer lab in graduate school just to get more hours on the mainframe, that kept me awake at night, as a kid, solving puzzles in my head, that fueled my every workday – had gone missing. I’d spent two decades building a train and laying its track. Now, the thought of merely driving it struck me as a far less interesting task. Was making one film after another enough to engage me? I wondered. What would be my organizing principle now? My desire to protect Pixar from the forces that ruin so many businesses gave me renewed focus. I began to see my role as a leader more clearly. I would devote myself to learning how to build not just a successful company but a sustainable creative culture. As I turned my attention from solving technical problems to engaging with the philosophy of sound management, I was excited once again – and sure that our second act could be as exhilarating as our first.”

– Pixar’s founder Ed Catmull in Creativity, Inc: Overcoming the Unseen Forces That Stand in the Way of True Inspiration

For the last 50 years in Singapore and Asia, which is built on the foundation of the farsighted pioneers who established the place as a magnet of FDI flow and MNCs, all firms and entrepreneurs had to do was answer the phone from clients and lease more office space. And excess profits are used to reinvest in trading and accumulating property assets and financial engineering activities. “Positional leadership” are prized on those who can maneuver the giant organizational machinery with their “well-rounded” skill-set and climb to the apex. That run is possibly over. Relationship-based deal-making capabilities coupled with access to cheap financing have experienced diminishing marginal returns, even losses, and internal in-fighting and succession woes have fueled a hidden vicious race to the bottom in accounting tunneling of group resources that is hidden at the surface. Like an inverted U-curve that was also highlighted earlier in May 2013 in Pilgrimage to Omaha + Entrepreneurship, Asian-Style:

“As value investors in Asia should know, path dependency has influenced the Southeast Asian (ASEAN) economy, which is the product of a relationship between political patronage and economic elitist power that developed in its initial starting point in the colonial era, and this politics-business nexus was sustained with a different cast of characters. Bet on the wrong jockey (entrepreneur) and the race is over. The Asian horse (business) doesn’t matter much; the ownership of the horse can change, a far more important information to monitor and analyze. Alas to the ones who are not in the insider’s track. These big Asian horses are often grants to quasi-monopoly or regulated/ protected concessions, normally in domestic goods and services industries without a requirement to generate the technological capabilities to compete on the global arena. These asset-based, deal-making trading businesses that form the foundation of many Asian tycoons are akin to elite forms of barber-like “services” in which the fiercely global competition cannot attack with impunity, such as commodities, construction/ infrastructure/ property, financial services. As Joe Studwell pointed out in his insightful book “Asian Godfathers: Money and Power in Hong Kong and Southeast Asia”, Southeast Asia has all the trappings of a modern dazzling economy with its high-tech factories and high-rise buildings but few indigenous, large-scale companies producing world-class products and services. The scraps that trickle down the big, long tables of the Asian tycoons are left to be competed fiercely in a lose-lose situation at the SME level. Even with the export-driven boom, the SME’s role as middlemen in taking and executing orders efficiently from their MNC customers has limited the scalability of their business model.”

Growth and entrepreneurship in Asia is not driven by innovation and science given that every creative field — innovation, science, music, movies, books, art — follows a Power Law. They bring into the world richly valued things which did not exist before. And these creations like Pixar take time and effort of a different nature as compared to the asset-based, deal-making trading businesses and positional leadership skill-set for big corporates in Asia.

From Pixar’s founder Ed Catmull story encapsulated in his inspiring book Creativity, Inc, we can sense and observe that the true innovator and compounder have:

• An idea larger than oneself that fuels their internal sense of purpose
• A burning desire to harness the voice of everyone so that everyone can be co-creators and be involved in the value creation process
• Faced rejection, tasted temptations, are highly misunderstood, and are ever more determined to stay focused, to just work with a palpable sense of urgency, to realize the intangible ideas and Purpose, to keep the flames burning
• Expressions of gratitude, the ability to see value in problematic situations as areas to improve through providing his or her service

Our mental model for navigating the Big Transition in Asia is to identify the Pixars and Bamboo Innovators, investing in the emerging tycoons, the innovators and the wide moats they are building – before they become obvious. We have discussed earlier about the philosophy of “Good is not the absence of evil”: how the value investor can only eliminate the “evil” ones with potential misgovernance and accounting tunneling fraud to limit downside risks – and still neglect and overlook the “good” compounders. And each time round there is a credit crisis punctuating the markets, there is an increasing premium on valuation for wide-moat business models in Asia as the Innovators stood apart from the Imitators and the swarming Incompetents. Value investors in Asia need to take the leap to become more Munger-like in selecting companies with wide moats that can generate compounding returns rather than dwell with a false sense of security in the realm of statistically cheap stocks that turn out to be either fraudulent or value traps.

Starting next week, we will start expanding on these thoughts of finding the emerging tycoons in Asia and the wide moats they are building – before they become obvious. As we have highlighted in “Any Benjamin Franklin in Asia? (Part 2): Reflections from the Story of Linkabit-Qualcomm and the Inverted U-Curve of Singapore/Asia”:

“True compounders have no time to waste and their brains and time are purposed towards ideas larger than themselves. In our interaction with Asian management over the past decade plus, the Bamboo Innovator like to sense this almost child-like fervour and time spent for ideas, which in the Asian context is deemed immature and foolish since the successful wealthy towkays feel that the mind should be occupied by the loud thought of “can make money or not” or “can be more famous and prominent or not”. That makes the difference between a wealthy local tycoon who creates wealth largely for himself or herself with the usually visible display of lifestyle to portray success and posturing activities to gain fame and social respect as compared to the quiet low-profile inventor-entrepreneurs who lived in the basement constantly thinking and worrying and keeping the ideas burning towards the flames of creation and scaling up.”     

As we have discussed, a checklist approach in examining “successful” companies might overlook the resilient Bamboo Innovators. After all, there are much larger impressive trees in the forest. By comparison a bamboo looks smaller, thinner, and fragile. The list of Bamboo Innovators is a surprising one; many of them are not the typical ones that one would come across. While the details are always different, certain features of the Bamboo Innovators are remarkably similar to those that resulted in the astonishing vitality in bamboo: the R.E.S.-ilience factors in value creation.

• R stands for “Rootedness” in cultivating a culture of kindness, trust and cooperation to contend with and heal creative dissent and incentivize innovative experimentations.
• E for “Emptiness” like the empty hollow center of a bamboo in having (1) “indestructible intangibles” which in turn derives its strength from either a certain know-how or trust and support in the community; (2) a “core-periphery” network; and (3) an “open-innovation” business model in which both internal and external partners co-develop new products and creations
• S for “Sheath” in leadership to create the context, adaptive-govern, coordinate, synthesize and weave diverse networks and groups who might otherwise be excluded into a coherent whole, rather than the typical command-and-control “positional/title-based” leadership .

Sheaths are not the most obvious structures on a bamboo plant, but they are, perhaps, the most complicated. As the bamboo shoot breaks through the earth’s surface and reaches for the sun, it is covered and protected by a set of distinctive sheaths. Every soft and vulnerable emerging node of rhizome (root), culm, or branch bears a sheath that protects it during growth until it hardens. The outer surface of the culm sheath is usually tough while the inner surface is always smooth and glossy which allows the internode to rise rapidly through its casing. Similarly, upon crafting the culture and creating the context for resilient growth, sheath leaders play the role of protecting emerging nodes of innovation at the periphery from harm. An illuminating example would be how Singapore’s founding Prime Minister Lee Kuan Yew cleared the political obstacles and laid the ground to allow for the innovations devised by his key economic architect Dr. Goh Keng Swee to be implemented, as commented by Lee himself in his eulogy for Goh on 23 May 2010: “He [Goh Keng Swee] was my trouble-shooter. I settled the political conditions so that his tough policies we together formulated could be executed.”

Like its tough outer surface, sheath leaders are brutally honest in recognizing a problem rather than to pretend there is none. Without gratitude, honesty cannot be brought out meaningfully, since gratitude is the ability to see value even in humble, unremarkable and problematic situations as areas to improve through providing his or her service. Gratitude is antiheroic. It does not depend on courage or strength or talent. It is based on our incompleteness and born only where solidarity and the awareness of problems are present. If we are honest and do not hide it from ourselves, we can proactively work to receive the goodness and opportunities that life offers us and we can be grateful.

With its smooth inner surface, sheath leaders are able to weave diverse networks and groups who might otherwise be excluded into a coherent whole, quite unlike the typical command-and-control “position/title-based” leadership Sheath leaders are able to give voice to the unpopular, unconventional, unorthodox views to foster innovation.

With this understanding of Sheath leadership in the Bamboo Innovator framework, we like to briefly discuss about Taiwan Paiho (TWSE: 9938 TT) which is up 80% since we highlighted the company in our Monthly Moat report in March 2014. Paiho is the world’s largest touch fastener tape maker (1.3m km/yr, >10% market share) with applications in apparel, shoes, diapers, car seats etc. All top 20 global athletic shoe brands, including Nike, Adidas, Reebok, Sketchers, UnderArmor are customers whom Paiho has forged long-term “spec-in” partnerships with.

Taiwan Paiho (TWSE: 9938 TT) – Stock Price Performance Vs Taiwan Formosa Stock Index

What struck us was how Paiho founder and CEO Vergil Cheng tried to cultivate a sustainable culture of innovation by giving voice to diverse views so that everyone are co-creators in the value creation process rather than just a few dealmakers/rainmakers or the emperor himself, the same mindset as Pixar’s Ed Catmull:

“The importance of R&D cannot be emphasized enough; it’s akin to helping the engineers and developers to “carry books”. At Paiho, all business unit managers and supervisors and above are automatically listed as a R&D personnel and can present their idea proposal. When a R&D project requires funding and the supervisor dare not make the decision whether or not to proceed, the business owner can provide his or her opinion. The investment opinion must not be based on the general macroeconomic outlook, but whether the specific product can have a breakthrough market potential.*“

Cheng explains how innovations enabled Paiho to pursue unique opportunities to widen its economic moat:

“Winning in a price war is a transient race; continuous innovation in product quality is like a marathon and the sustainable way to win. A pair of branded sports shoe is around TWD 2,000-3,000 ($66-100). So if the tape fastener in the branded shoe is of an inferior quality, the customer will scold the brand owner and not the fastener supplier. So the brand owner will be very strict in selecting the best supplier and not go for the lowest price supplier. Paiho is one of the rare few Taiwan and even Asian shoe materials company with proven R&D capabilities and is involved in the design stage with the client before the new product is launched. Our “spec-in” long-term partnerships with all the top 20 athletic sports shoe companies develop new materials/designs and provide better and patented solutions to avoid price competition and maintain stable margin. We send 8,000 pieces of sample products to our clients for them to do their trial tests. Only by doing co-R&D work with the world’s best brands and growing together with them can we provide the best customer service and solution, to master and even lead the industry trend. Our comprehensive product range is also protected by over 110 patents. Some of these patented innovations include our water-resistant tape fastener which can maintain its ‘stickiness’ in the water and is designed for water sports activities.*”

We particularly like a profound quote by Pixar’s Ed Catmull:

“Imagine an old, heavy suitcase whose well-worn handles are hanging by a few threads. The handle is “Trust the Process” or “Story is King” – a pithy statement that seems, on the face of it, to stand for so much more. The suitcase represents all that has gone into the formation of the phrases: the experience, the deep wisdom, the truths that emerge from struggle. Too often, we grab the handle and – without realizing it – walk off without the suitcase. What’s more, we don’t even think about what we’ve left behind. After all, the handle is so much easier to carry around than the suitcase.”

We think that there are many thoughts and statements about how Asia needs to be more entrepreneurial and innovative, akin to Ed Catmull’s “handle” trying to lift up the old, heavy suitcase of Asia. Unless one has a R.E.S.-ilience handle and framework to carry this suitcase, it will be difficult to invest in the emerging tycoons, the innovators and the wide moats they are building, like Taiwan Paiho and Vergil Cheng – before they become obvious – and uncover the hidden wealth inside during this critical transition period and in the coming decades ahead.

*Chinese to English translation by KB Kee. Any translation errors are KB’s.

Warm regards,

KB

The Moat Report Asia

www.moatreport.com

http://accountancy.smu.edu.sg/faculty/profile/108141/KEE-Koon-Boon

A new monthly issue of The Moat Report Asia is now available!

Access the in-depth idea presentation:

http://www.moatreport.com/members/

• The weekly insight is a teaser into the opportunities – and pitfalls! – in the Asian capital jungles.
• §  Get The Moat Report Asia – a monthly in-depth presentation report of around 30-40 pages covering the business model of the company, why it has a wide moat and why the moat may continue to widen, a special section on “Inside the Leader’s Mind” to understand their thinking process in building up the business, the context – why now (certain corporate or industry events or groundbreaking news), valuations (why it can compound 2-3x in the next 5 years), potential risks and how it is part of the systematic process in the Bamboo Innovator Index of 200+ companies out of 15,000+ in the Asia ex-Japan universe.
• Our paid Members from North America, Europe, the Oceania and Asia include professional value investors with over $20 billion in asset under management in equities, some of the world’s biggest secretive global hedge fund giants, and savvy private individual investors who are lifelong learners in the art of value investing.

This was the hissing sound made by Computer Associates’ Chairman and CEO Sanjay Kumar before he was later sentenced to 12 years in prison for his role in the $2.2 billion accounting fraud. The accounting disclosure of words — the level of disclosure (how much you say), its tone (what do you mean), and its transparency (how you say it) — can be an additional helpful tool for investors and regulators to ferret out the Asian Snake engaging opportunistically in accounting fraud.

As Buffett puts it wisely: “Under any rules, if the CEO, wants to obfuscate, they can do that; and if they want to make it clear, they can do that. If they want to provide you with fluff, they can do that. If they want to provide you with substance, they can do that. The CEO will look at any rules through his own particular glasses, and either look at them as a way to give his shareholders more information, or to do some kind of tap dance number.”

Despite the approximately 50/50 mix in preparing financial disclosures, the overwhelming focus is on accounting numbers. Significantly less time is spent looking at the context or the communication of these numbers. Opportunities are thus presented for investors and regulators to analyze not only the text of the Annual Report, Management Discussion & Analysis (MD&A) sections and IPO prospectuses, but also press releases, conference calls, and management interviews, etc. Investors may scrutinize the content for truthful revelation or opportunistic structuring of language in these situations by managers intent on hiding adverse information from investors. We will be examining and applying textual and unstructured data analysis tools – such as the FOG Index, the Narcissism Index, Tone Management, the 4Cs (Candor, Context, Complexity/ Confusion, Contradictions/ (in)Consistencies) etc – in different real-world western and Asian cases, including understanding their limitations.

Week 1 – Survival in the Asian Capital Jungle: Who Knows What When? (108 slides)

Week 2 – Western Tools to Catch An Asian Snake? (111 slides)

Week 3 – The Incentivized Asian “Wedge” Snake to Tunnel Corporate Wealth (revised to 105 slides from 86 slides)

Week 4-5 – Shedding of the Asian Snake’s Skin, The Opportunistic Tunneling of Corporate Wealth (157 slides)

Week 6 – Descend into the Asian Snake’s Lair, Occult Offshore Centers, Tax-Tunneling, and Consolidation Craftiness (89 slides)

Week 7-9 – The Asian Snake Charmer and Stock Manipulation Scheme  (112 slides)

Week 10 – The Accounting of Words & The Hiss of the Asian Snake (57 slides)

Warm regards,

KB

The Moat Report Asia

www.moatreport.com

http://accountancy.smu.edu.sg/faculty/profile/108141/KEE-Koon-Boon

A new monthly issue of The Moat Report Asia is now available!

Access the in-depth idea presentation:

http://www.moatreport.com/members/

• The weekly insight is a teaser into the opportunities – and pitfalls! – in the Asian capital jungles.
• Get The Moat Report Asia – a monthly in-depth presentation report of around 30-40 pages covering the business model of the company, why it has a wide moat and why the moat may continue to widen, a special section on “Inside the Leader’s Mind” to understand their thinking process in building up the business, the context – why now (certain corporate or industry events or groundbreaking news), valuations (why it can compound 2-3x in the next 5 years), potential risks and how it is part of the systematic process in the Bamboo Innovator Index of 200+ companies out of 15,000+ in the Asia ex-Japan universe.
• Our paid Members from North America, Europe, the Oceania and Asia include professional value investors with over $20 billion in asset under management in equities, some of the world’s biggest secretive global hedge fund giants, and savvy private individual investors who are lifelong learners in the art of value investing.

The Machine Behind “Mass Flourishing” and the Artisan Revolution

When China’s Premier Li Keqiang was in Africa in May 2014, he gave away a particular machine to the African people as a gift to highlight the global competitiveness of China products and to promote the ‘Love Made-in-China Product’ idea. After his trip, he was told that they were made by a hidden wide-moat champion from another Asian country. Out of the 11 million units sold worldwide every year, 3.3 million are manufactured by this Bamboo Innovator in 2014, or nearly 1 out of 3 machines, tripled from 1 million units in FY2005.

Li was partly inspired by a book called “Mass Flourishing: How Grassroots Innovation Created Jobs, Challenge, and Change”, that innovation comes from the grass roots rather than top-down planning laboratories, so everyone can contribute; and that innovation contributes to personal growth – or “self-development,” as Li phrases it. Interestingly, this product is behind the handicraft revolution enabled by Etsy, the fifth most-visited website in the U.S., after Amazon, eBay, Walmart and Best Buy. Etsy is said to be planning to raise $300m in an IPO this year, the biggest IPO to come out of New York since 1999. An article last week talks about a lady who is said to have sold $80,000 worth of merchandise on Etsy and earning about $65,000 a month: “I really wanted to be able to sell the products and make a few extra dollars for dance lessons for my children. I would have been thrilled to make $100 to $200 a month to pay for my daughter’s dance lessons. I’ve tasted loss and felt what it does to you personally. Second chances are so much more appreciated.” Etsy is part of a rising trend of companies that enable the freelance economy. Like Uber, AirBnB, these companies allow people to do what used to be full-time work as part-time gigs, or to strike out on their own instead of working for an established company. It gives more choice to consumers while enabling people in need of cash to easily pick up extra work. Etsy is part of the maker movement led by housewives and avid DIY crafters.

Our latest monthly Moat Report Asia for March 2015 examines an Asian company that was established in 1968 and is now the world’s largest ODM (Original Design Manufacturer) in the machine behind this mass flourishing and the handicraft revolution with a 30% global market share. This company has focused on this product for the past 40-plus years and does not carry major non-core investments on its balance sheet.

There are over 400-500 different precision engineering parts that go inside this product, which is far more than the 25-30 parts that are needed to make a modern smartphone. Just one malfunctioning part, or if the parts do not coordinate with one another, and the entire product would have to be discarded. Thus, the complexity in manufacturing and coordinating hundreds of parts in the machine can result in production challenges, working capital and inventory management problems, delivery delay, and lost clients. The company designs and makes 40-50% of the machine parts in-house, while most of its peers purchased the parts.

The company recognized early on the importance of R&D in order to quickly launch new models and products for its clients who require speed-to-market in introducing new designs for the end consumers. Because the company proactively proposed the designs, they have control and power over the backbone system and structure in the hundreds of internal parts inside the machine. This is crucial because it translates into tangible procurement and cost advantages. As the company’s Chairman Mr. L puts it: “Only when you have R&D capabilities can your road be wider in the long competitive journey. This is our secret to why we enjoy a powerful cost advantage over our rivals that they find very hard to replicate!”

As a result of its vertical integration strategy and R&D capabilities, the company has consistently the highest ROA, ROE, profit margin and working capital efficiency in the industry despite rising cost pressures and the volatile cycle. ROA at 13.2% and ROE at 18.9% is significantly higher than its rivals. Its inventory management is also very impressive at only 36 days (vs peers’ 60-90 days), an extraordinary feat given that there are 400-500 parts to manage.

The company has demonstrated remarkable resiliency in winning in industry crisis over the past 47 years, forging formidable competitive advantages in scale, product quality, R&D design capabilities. In each industry crisis and consolidation phase, the company is able to emerge as a winner and continue onward its growth path in a traditional, boring industry that is experiencing resurgence with the handicraft revolution.

Valuation is also decent and reasonably cheap for a world-class company at PE 12.1x, EV/EBIT 9.6x and EV/EBITDA 8.2x. Its short-term downside is protected by its healthy net cash balance sheet and an attractive 5.3% dividend yield. With the handicraft revolution enabled by Etsy-like online marketplace, as well as growth in demand in emerging markets in China, Russia and ASEAN, Latam, EBITDA and net profit could potentially double, pointing towards a 120-180% growth in market value to $720-900m based on a modest EV/EBITDA 12-15x.

We are most impressed by the company’s corporate culture. Led by Mr. L, the corporate culture has been a nurturing one towards cultivating continuous R&D innovations and the philosophy of owner-operator mindset at every level of the company:

Q: “After all these years, what is the one thing or one event that is the most memorable or touches your heart the most?”

Mr. L: “I am most touched by the dedication of our employees towards the company. During the natural disaster in.., [our factory site] was in the catastrophic zone.. Yet, our employees continue to come to work, with the collective understanding and commitment that ‘if we receive orders, we have the responsibility to deliver them’. With courage and tears, [Company’s name] overcame the challenges and managed to stand up once again. I was appointed the Chairman in 2002 and I put greater emphasis on human capital development, from training to career advancement opportunities and performance-based compensation. I actively promoted the philosophy of owner-operator mindset at every level of the company, that ‘[Company’s name] belongs to everyone’, to continue the spirit that touches my heart during the disaster. As we rebuilt the buildings and factory that were destroyed, we have cultivated a revolutionary feeling.”

We think this is rare in Asian firms and the company deserves a valuation premium.

Who is Mr. L and this wide-moat Bamboo Innovator?

PS: We are very honored to be able to invite Mr. Hemant Amin, Founder, Chairman and CEO of Asiamin Capital, a successful single family office, and Founder and Chairman of the BRKets investor group (www.brkets.com) to be the guest speaker on March 17 (Tuesday) at 5.30pm till 7pm. Mr. Jarrod Baker, the Senior Managing Director at NYSE-listed forensic specialist FTI Consulting Inc (NYSE: FCN, MV $1.5bn), was our previous guest speaker and his presentation materials are available here. Hemant will be talking about accounting fraud in Asia with actual Indian cases from his wealth of experience in investing in Asia and India, where he is an early investor in Narayana Murthy’s Infosys which compounded over 60-folds for him: http://www.beyondproxy.com/grey-world/. KB will be moderating in the second half of Hemant’s session which will be in the dialogue-style.  We will be making this exclusive content available for our Moat Report Asia subscribers only.

Warm regards,

KB

The Moat Report Asia

www.moatreport.com

http://accountancy.smu.edu.sg/faculty/profile/108141/KEE-Koon-Boon

A new monthly issue of The Moat Report Asia is now available!

Access the in-depth idea presentation:

http://www.moatreport.com/members/

• The weekly insight is a teaser into the opportunities – and pitfalls! – in the Asian capital jungles.
• Get The Moat Report Asia – a monthly in-depth presentation report of around 30-40 pages covering the business model of the company, why it has a wide moat and why the moat may continue to widen, a special section on “Inside the Leader’s Mind” to understand their thinking process in building up the business, the context – why now (certain corporate or industry events or groundbreaking news), valuations (why it can compound 2-3x in the next 5 years), potential risks and how it is part of the systematic process in the Bamboo Innovator Index of 200+ companies out of 15,000+ in the Asia ex-Japan universe.
• Our paid Members from North America, Europe, the Oceania and Asia include professional value investors with over $20 billion in asset under management in equities, some of the world’s biggest secretive global hedge fund giants, and savvy private individual investors who are lifelong learners in the art of value investing.

Vivid cases of Asian Snake Charmers include Harshad Mehta, Ketan Parekh, Tang Wan Xing (唐万新), Pin Chakkaphak and many more. The Asian Snake Charmer becomes one with the Asian Snake and is a manipulator of thoughts. In a timely fashion the evil one inserts thoughts into our minds hoping that we would adopt them for ourselves. If we can understand temptations and the Truth, we can break the spellbound enchantment.

Week 1 – Survival in the Asian Capital Jungle: Who Knows What When? (108 slides)

Week 2 – Western Tools to Catch An Asian Snake? (111 slides)

Week 3 – The Incentivized Asian “Wedge” Snake to Tunnel Corporate Wealth (revised to 105 slides from 86 slides)

Week 4-5 – Shedding of the Asian Snake’s Skin, The Opportunistic Tunneling of Corporate Wealth (157 slides)

Week 6 – Descend into the Asian Snake’s Lair, Occult Offshore Centers, Tax-Tunneling, and Consolidation Craftiness (89 slides)

Week 7-9 – The Asian Snake Charmer and Stock Manipulation Scheme  (112 slides)

In the words of the late economic architect Dr. Goh Keng Swee, we desire to “explain, inform and educate” our abhorrence of stock manipulation schemes and potential accounting frauds in the Asian capital jungle.

We hope that the regulatory authorities in Asia will take a more serious and proactive (as opposed to reactive) approach to tackling stock manipulation and potential accounting frauds and restore trust in the capital markets. The large transfer of wealth from outsiders to insider manipulation significantly discourages how much and how many outside investors choose to invest in the market. The presence of manipulators impose large participation costs for genuine participants trying to either invest or raise capital in equity markets and explain why market reforms are hard to implement and emerging equity markets remain a fertile playground for the professional manipulators and insiders who have the incentive and power to manipulate prices, volumes, information and to inject “action” to lure investors and then offloading in a pump-and-dump scheme via related-party and accounting money-go-round transactions.

We need to make right the capital market phenomenon that the sagacious Peter Bernstein aptly described: “The ‘gulls amongst the public to feed the maws of professionals’ seem to replenish itself with remarkable regularity regardless of how many gulls drop out along the way.”

Happy Chinese New Year to everyone – we wish you Health and Happiness in the year of the Sheep!

PS1: We will resume on 2 March 2015.

PS2: We are in very preliminary and basic discussion with an established fund house with an illustrious hundred-year-old history and an Asian listed company about a potential collaborative effort to employ the Bamboo Innovator methodology to systematically identify and invest in neglected, misunderstood and underappreciated wide-moat resilient business models. Heavy lifting work is done in eliminating Asian companies with a higher likelihood of Asian-style accounting tunneling fraud via related-party transactions, misgovernance risks and the alluring value traps without a resilient and innovative business model. The portfolio investments in the top Asian Bamboo Innovators will be housed in the ETF-index and fund products with disciplined stock selection process and scalable fund capacity build-up. We sincerely hope that this potential long-term project can materialize for the investment community and public. We are grateful to have your kind patience and valuable support and we like to express our heartfelt thanks to you, our Subscribers to the Moat Report Asia. We assure you that we are thinking and working hard to continually add value and bring authenticity for you, our Moat Report Asia Subscribers.

Warm regards,

KB

The Moat Report Asia

www.moatreport.com

http://accountancy.smu.edu.sg/faculty/profile/108141/KEE-Koon-Boon

A new monthly issue of The Moat Report Asia is now available!

Access the in-depth idea presentation:

http://www.moatreport.com/members/

• The weekly insight is a teaser into the opportunities – and pitfalls! – in the Asian capital jungles.
• Get The Moat Report Asia – a monthly in-depth presentation report of around 30-40 pages covering the business model of the company, why it has a wide moat and why the moat may continue to widen, a special section on “Inside the Leader’s Mind” to understand their thinking process in building up the business, the context – why now (certain corporate or industry events or groundbreaking news), valuations (why it can compound 2-3x in the next 5 years), potential risks and how it is part of the systematic process in the Bamboo Innovator Index of 200+ companies out of 15,000+ in the Asia ex-Japan universe.
• Our paid Members from North America, Europe, the Oceania and Asia include professional value investors with over $20 billion in asset under management in equities, some of the world’s biggest secretive global hedge fund giants, and savvy private individual investors who are lifelong learners in the art of value investing.

Q: “[The Company] has played an instrumental and leadership role in modernizing the country’s industry in the last 50 years. Can you share with us your thoughts about the company’s next 50 years?”

Mr. J: “The 50-year-plus journey for [the Company] since 1962 has been a soul satisfying one. [The Company], which has been successful throughout, delivers to the user industry its Founder Chairman’s vision of providing the industry with world class machinery at affordable prices. The company so far has serviced the industry with the installation of over 36 million [industry units in technical term] in the country, contributing to the competitiveness of the industry at the global level. We have with us a heritage of 50 years, thanks to the far-fetched vision of the Founder Chairman, flawless execution of strategy by our past Chairman and Managing Director, efforts of our employees and the trust of our customers. [The Company’s] relationship with customers does not end with supply of machinery. [The Company] has always been like a partner to the end-user and is involved right from the planning stage to execution of the plant, followed by after-sales service and components support. [The Company] today is a social institution that dynamically interacts, fosters, supports and benefits many stakeholders. Leadership through Excellence will guide [the Company] in the next 50 years. We strive with total dedication and conviction. All our plans and actions are driven by our objective – Innovation and Value Creation to all our stakeholders. With continuous R&D and offering products required for the user industry, [the Company] is sure to maintain the market leadership.”

Q: “You have proven yourself to be an exceptional entrepreneur and resilient business leader by navigating [the Company] through the difficult period in 2010-12 that saw the former Chairman passing away, the long-time partner parting ways and selling off their equity stake in [the Company], and the recession in the industry when [the Company] ‘celebrates’ its jubilee year. Do you have any words of advice for the younger generation and the students?”

Mr. J: “Students should aspire to start small businesses that can blossom into big businesses. Students have to work smart, continue to update their knowledge and sharpen their skills, if they wish to stay ahead in the competitive world. The world has become very competitive and demanding. It is very impatient. You have to prove yourself worthy in a short period. Otherwise, you will be left behind in the crowd.”

Developing a sense of urgency to stay ahead in the “impatient” competitive world is essential, as both Mr. J and Leonardo Da Vinci testify. The maestro Bamboo Innovator Da Vinci illuminated the wisdom: “I have been impressed with the urgency of doing. Knowing is not enough; we must apply. Being willing is not enough; we must do.”

Can you guess who is this family business leader Mr. J? Our latest monthly Moat Report Asia for February 2015 examines an Asian company established by Mr. J’s grandfather in 1962, now the #1 undisputed leader in the [industry technical term] industry with a domestic market share of 60% by value and 70% by volume, far ahead of its Switzerland rival’s 15% market share. Globally, the company is #3 with a 10% market share, behind the Swiss firm (23%) and a privately-held German firm. The company is one of the only three companies in the world that manufactures the complete range of the [industry technical term] machinery. The company has played a significant role in making the [industry technical term] industry globally competitive. It is no exaggeration to say that there is an [company’s name] machine in every [industry term] in its home country which has a current total capacity of 52 million [industry units in technical term] countrywide. The company has over 1,300 domestic customers out of a total of around 1,600.

What makes It a wide-moat business? Some factors include: (1) Superior aftersales network: The company has service centers in each [industry term] hub of the country, while peers have only 3 to 4 centers. In the [industry term] industry, machinery related technical problems need to be rectified at the earliest, as the downtime significantly affects production and profitability of [industry term]. The company’s technicians are able to reach a customer’s site to rectify problems within 24 hours, resulting in the company to be the preferred choice. (2) Network effect of huge customer base: Over the decades, the company has developed its customer network across the country and earned the reputation of being a premier supplier of machinery in the country. The high customer base provides a strong competitive edge to the company over the western players setting up manufacturing facilities in the country. The machinery can last for a period of 25-30 years and many leading companies regularly modernize their machinery by replacing old machines with newer ones. Thus, there is a strong secondary market for [industry term] machinery. Players hence prefer the company over European and peer companies as the company’s spare parts are cheaper and they are also unsure of the second hand value of other machinery. (3) Bargaining power to collect 10% advances to fund working capital: The company collects 10% of the estimated value of the machine as advance, which is non-refundable and interest-free. The advances were used to fund its working capital, thus reducing business and financial risk substantially. Thus, unlike other capital goods and engineering firms, which are sitting on a pile of debt, the company has net cash equivalent to 20% of its market value.

The company has consistently the highest ROA, ROE, profit margin and working capital efficiency in the [industry technical term] machinery industry despite rising cost pressures and the volatile cycle. ROE at 9.1% and ROE at 17.1% is significantly higher than its 200-year-old Swiss key rival at 3.5% and 10.1% respectively. The company is also able to generate double the net profit margin at 8.1% as compared to 3.8% for its Swiss rival. The company’s cash conversion cycle at 13 days is arguably the most efficient amongst machine makers due to its collection of a non-refundable 10% cash advance from customers. The company’s inventory management is also very impressive at only 52 days, an extraordinary feat given that the production delivery for the machines is 8-12 months due to the industry nature of its complexity and high-value. The company has built tremendous scale in the secondary market for its machines and parts in its home market, the second largest [industry term] market in the world, giving it a strong recurring cashflow foundation to expand overseas. The abandonment of Swiss franc floor against Euro made Swiss exports much less competitive. As a result, the company is likely to extend its lead over its key Swiss rival in its home country. It presents an opportunity for the company to leap ahead of its less competitive Swiss rival in the exports business. Valuation is also decent and reasonably cheap for a world-class company with EV/EBIT 10.2x and EV/EBITDA 7.8x. The company’s short-term downside is protected by $142m in net cash and debt-free balance sheet to weather any volatility in the industry cycle. Despite being a world-class company, the company is unknown amongst foreign investors and neglected with FII interest at only 1.86%.

Third-generation leader Mr. J joined the family business in 1993 and has proven so far to be a resilient entrepreneur by navigating the company through the difficult period in 2010-12 that saw the former Chairman passing away, its partner parting ways and selling off their equity stake in the company, and the recession in the industry. Having withstood the crisis when it was “celebrating” its jubilee (50th) year, the company looks set to build upon the momentum from the neglected “windfall” gain from the Swiss franc adverse impact on its key Swiss rival to extend its domestic leadership and expand overseas. [Industry term] machinery players are the earliest beneficiaries of [industry term] sector growth and the company is the best early-mid cycle play on [industry term] growth with the prospect of investment in [industry technical term] internationally and the company is poised for the next upsurge.

Who is Mr. J and his listed family business?

PS1: We are very honored to be able to invite the Senior Managing Director of FTI Consulting (FCN US, MV $1.5bn), a billion-dollar NYSE-listed global forensic consulting firm, as a guest speaker on 9th February. Over the years in the Asian capital jungles, the FTI people are amongst the few professionals whom I respect for their on-the-field expertise and thought leadership in the area of fraud and forensic investigation. I am sure that the talk will definitely make an impact who will learn not only invaluable lessons from the speaker’s knowledge and wisdom but also about FTI Consulting as their future choice of a long-term fulfilling career. We will be making this exclusive content available for our Moat Report Asia subscribers only.

Warm regards,

KB

The Moat Report Asia

www.moatreport.com

http://accountancy.smu.edu.sg/faculty/profile/108141/KEE-Koon-Boon

A new monthly issue of The Moat Report Asia is now available!

Access the in-depth idea presentation:

http://www.moatreport.com/members/

• The weekly insight is a teaser into the opportunities – and pitfalls! – in the Asian capital jungles.
• Get The Moat Report Asia – a monthly in-depth presentation report of around 30-40 pages covering the business model of the company, why it has a wide moat and why the moat may continue to widen, a special section on “Inside the Leader’s Mind” to understand their thinking process in building up the business, the context – why now (certain corporate or industry events or groundbreaking news), valuations (why it can compound 2-3x in the next 5 years), potential risks and how it is part of the systematic process in the Bamboo Innovator Index of 200+ companies out of 15,000+ in the Asia ex-Japan universe.
• Our paid Members from North America, Europe, the Oceania and Asia include professional value investors with over $20 billion in asset under management in equities, some of the world’s biggest secretive global hedge fund giants, and savvy private individual investors who are lifelong learners in the art of value investing.

Last week, we shared that In practice, the controlling owner and insiders net less than the full amount that they have tunneled and expropriated because of lawyer fees, tax consultants, payment for discrete financial services etc. We will unearth some shocking empirical findings that can possibly help investors to detect and avoid Asian accounting frauds ahead of the curve, in the form of abnormal levels of professional fee. These include Big 4 audit firms receiving more audit and non-audit fees when their clients transfer more money to fraudulent entities. However, it is difficult to distinguish if the excess fees are a form of price protection by the Big 4 auditors when they take on risky clients or represent payments for not constraining their clients’ fraudulent transfers. A one standard deviation increase in income diversion is said to correspond to 9.4% increase in audit fees at the Big 4 and a one standard deviation increase in income diversion corresponds to 24.1% increase in non-audit fees at the Big 4…

Still, this “professional fee” pales in comparison to that enjoyed by another important capital market participant in the Asian jungle. First understand this: How much money can be tunneled and diverted from such “spaceman” schemes? Typically 40%. Because the amount diverted and tunneled can be large and is usually paid in cash, spaceman schemes require the collaboration of bank officials. These bank officials often charge fees of as much as 5% for customers to withdraw cash and it is a lucrative business.

Over the weekends, shocking news broke out that China Minsheng Banking Corp (600016 CH, MV $49.6bn) chief Mao Xiaofeng had resigned and was taken away by the Communist Party’s Central Commission for Discipline Inspection in connection to the anti-corruption probe of Ling Jihua, former top aide to ex-president Hu  Jintao. The investigation into the youngest-ever Chinese listed-bank president has exposed the tip of the iceberg of rampant power-for-money deals between senior officials and financial leaders.

It is estimated by the International Consortium of Investigative Journalists (ICIJ) that between $1 trillion and $4 trillion in untraced assets have left China since 2000. Nearly 22,000 offshore clients with addresses in mainland China and Hong Kong appear in leaked files obtained by ICIJ. Among them are some of China’s most powerful men and women. The files come from two offshore firms — Singapore-based Portcullis TrustNet and BVI-based Commonwealth Trust Limited — that help clients create offshore companies, trusts and bank accounts. Confidential documents obtained through ICIJ’s “Offshore Leaks” investigation show that Big 4 firms had a close relationship with Portcullis TrustNet, a Singapore-based offshore services firm that sets up hard-to-trace offshore companies for clients around the world. PwC, for example, helped incorporate more than 400 offshore entities through TrustNet for clients from mainland China, Hong Kong and Taiwan, the records show.

We will examine the off balance-sheet entities and financing such as VIE (variable interest entity) and operating leases, and revisit the reverse mergers. We will also look into the consolidation craftiness in accounting in intercorporate investments with regards to affiliates and JVs in Chinese firms, Korean chaebols and Japanese keiretsu and appreciate the mechanics of equity method vs the proportional consolidation method.

As we descend this week into the dark Lair, our spines tingle – we know we are closer to the Asian Snake.

Warm regards,

KB

The Moat Report Asia

www.moatreport.com

http://accountancy.smu.edu.sg/faculty/profile/108141/KEE-Koon-Boon

A new monthly issue of The Moat Report Asia is now available!

Access the in-depth idea presentation:

http://www.moatreport.com/members/

• The weekly insight is a teaser into the opportunities – and pitfalls! – in the Asian capital jungles.
• Get The Moat Report Asia – a monthly in-depth presentation report of around 30-40 pages covering the business model of the company, why it has a wide moat and why the moat may continue to widen, a special section on “Inside the Leader’s Mind” to understand their thinking process in building up the business, the context – why now (certain corporate or industry events or groundbreaking news), valuations (why it can compound 2-3x in the next 5 years), potential risks and how it is part of the systematic process in the Bamboo Innovator Index of 200+ companies out of 15,000+ in the Asia ex-Japan universe.
• Our paid Members from North America, Europe, the Oceania and Asia include professional value investors with over $20 billion in asset under management in equities, some of the world’s biggest secretive global hedge fund giants, and savvy private individual investors who are lifelong learners in the art of value investing.

Like Kaisa and many of the Asian companies, MKG had guaranteed the loan of its parent company who had used the money to speculate in the stock market, property and speculative ventures. In Dec 2000, MKG started an accounting “tunneling” exercise that shrunk group assets from RMB2.42bn to RMB371m, according to its biggest creditor Huarong Asset Management who bought RMB622m in MKG debt. Tunneling is the very reason why the recovery amount is always a small fraction of the audited net asset value, and the reason why western-style financial statement analysis, the elaborate spreadsheets of net-net asset value etc, break down as garbage-in-garbage-out exercise in the Asian capital jungle.

Loan guarantees presents a seemingly innocuous Opportunity to maliciously tunnel out corporate wealth in Asian companies.

Take the case of Olympus. It deposited ¥21bn in Japanese government bonds with LGT Bank and arranged for the bank to use these bonds as collateral for a loan to two shell companies, the “tobashi”. The unconsolidated shells in turn used the borrowed funds to buy the toxic investments from Olympus at the original cost. Olympus recorded the amount it deposited with LGT and the toxic assets were considered “sold” to the shells, thereby avoiding recognizing losses on these underwater securities. In other words, Olympus acted as a guarantor of loans made by the banks to the shells by depositing funds at the banks equal to the amount loaned (figure on left).

(L): Olympus accounting: DR Government Bonds ¥21bn, CR Cash ¥21bn; DR Cash ¥21bn (from the shells), CR Toxic Financial Assets ¥21bn (“sold” to shells); (R): Photo of MKG plant in the 1990s

Hence, cash in the balance sheet in Asian companies is invariably never really cash unless one examines these related-party transactions (RPTs), often held in scant regard by investors using western-style financial statement analysis and by Asian auditors. Even in Singapore, the Qualification Programme (SQP), a post-university professional accountancy qualification, does not cover at all the auditing of RPTs which is all-important in the Asian capital jungle.

The Monkey King is just one of the many brief cases that we will be sharing in Week 4 of the Accounting Fraud in Asia course in SMU. Last week, we have discussed about the Incentivized Asian “Wedge” Snake with indirect measurements of accounting tunneling using the complex and opaque corporate structures set up by the controlling owners. This week, we are making the breakthrough to explore the Shedding of the Asian Snake’s Skin: The Opportunistic Tunneling of Corporate Wealth with the direct measurements of accounting tunneling.

This Week #4 is a breakthrough in the sense that we are exploring new frontiers that have NOT been discussed even in top-tier accounting and finance research journals since the Asian Snake has adapted itself to escape the various measurements devised by researchers and practitioner. Take loan guarantee which has shifted to intercorporate loans, classified under “Other Receivables”. With some reforms mitigating these RPTs, the Asian Snake has adapted and shifted to other accounts in disguised forms. Hence our earlier article for a sense of urgency to develop a new composite measurement of tunneling. We will be dissecting both actual and potential real-world Asian accounting cases in this week and we’ll observe up-close the process in the shedding of the Asian Snake’s skin and the accounting transgression skin left behind.

PS: Our monthly Moat Report Asia will be out in the week of 6 February.

Warm regards,

KB

The Moat Report Asia

www.moatreport.com

http://accountancy.smu.edu.sg/faculty/profile/108141/KEE-Koon-Boon

A new monthly issue of The Moat Report Asia is now available!

Access the in-depth idea presentation:

http://www.moatreport.com/members/

• The weekly insight is a teaser into the opportunities – and pitfalls! – in the Asian capital jungles.
• Get The Moat Report Asia – a monthly in-depth presentation report of around 30-40 pages covering the business model of the company, why it has a wide moat and why the moat may continue to widen, a special section on “Inside the Leader’s Mind” to understand their thinking process in building up the business, the context – why now (certain corporate or industry events or groundbreaking news), valuations (why it can compound 2-3x in the next 5 years), potential risks and how it is part of the systematic process in the Bamboo Innovator Index of 200+ companies out of 15,000+ in the Asia ex-Japan universe.
• Our paid Members from North America, Europe, the Oceania and Asia include professional value investors with over $20 billion in asset under management in equities, some of the world’s biggest secretive global hedge fund giants, and savvy private individual investors who are lifelong learners in the art of value investing.

Two short Asian cases. After the onset of the 1997/98 Asian Financial Crisis, United Engineers Malaysia (UEM), a relatively healthy firm with strong growth prospects, bought out some management-controlled shares of its financially-troubled parent, Renong Corporation, at artificially high prices. Both firms are controlled by the same “family” (Halim Bin Saad via nominee accounts and connected to former finance minister Daim Zainuddin) through a pyramid structure. The buyout directly tunneled corporate wealth to the family at the expense of minority shareholders of both firms. Ting Pek Khiing, Chairman of the Ekran Group, issued shares in Ekran in May 1997 with the declared intention of purchasing shares in the holding company of Bakun Hydro-Electric Corporation, the operator of the largest hydroelectric project ever undertaken in Malaysia. Instead, as the crisis took hold, the money from the share issuance was ultimately used, via third parties, to buy out Ting’s stakes in several of the Ekran Group’s publicly traded affiliates. These are not the typical western-style accruals-based earnings management; they are artful Asian accounting tunneling methods to abuse minority shareholders. “Because I Can”, the controlling owners hissed. But how did they really carry out the tunneling? And how can we detect the incentivized Asian “wedge” snake that tunnels corporate wealth?

Warm regards,

KB

The Moat Report Asia

www.moatreport.com

http://accountancy.smu.edu.sg/faculty/profile/108141/KEE-Koon-Boon

A new monthly issue of The Moat Report Asia is now available!

Access the in-depth idea presentation:

http://www.moatreport.com/members/

• The weekly insight is a teaser into the opportunities – and pitfalls! – in the Asian capital jungles.
• Get The Moat Report Asia – a monthly in-depth presentation report of around 30-40 pages covering the business model of the company, why it has a wide moat and why the moat may continue to widen, a special section on “Inside the Leader’s Mind” to understand their thinking process in building up the business, the context – why now (certain corporate or industry events or groundbreaking news), valuations (why it can compound 2-3x in the next 5 years), potential risks and how it is part of the systematic process in the Bamboo Innovator Index of 200+ companies out of 15,000+ in the Asia ex-Japan universe.
• Our paid Members from North America, Europe, the Oceania and Asia include professional value investors with over $20 billion in asset under management in equities, some of the world’s biggest secretive global hedge fund giants, and savvy private individual investors who are lifelong learners in the art of value investing.

Interestingly, “2011” had happened before – in the late 1990s.

This week marks the 16th anniversary of the bankruptcy of GITIC (Guangdong International Trust and Investment Corp) on Jan 16, 1999, which was the biggest in the history of China to date, and still the first and formal of a major financial institution. The collapse of GITIC led to the closure of hundreds of trust companies and thousands of urban credit cooperatives. Zhu Rongji tasked financial wizard Wang Qishan, the current Vice-Premier and anti-corruption tsar, to clean up the mess. Accounting irregularities were uncovered in many Chinese companies that were affiliated to GITIC. The central government did not bail out GITIC despite great expectations and foreign bondholders in GITIC saw a recovery rate of 12.5%.

2011 is the year of the shadow banking crisis rearing its ugly head, akin to the late 1990s, leading to a tightening in credit conditions, which in turn resulted in companies finding it more difficult to opportunistically use the roll-away “other receivables” accounting tunneling trick with cheap money. The GITIC case informed us that many of the audited investment and financial assets that stood in the books of the balance sheet to generate “revenue” in the income statement did not belong to GITIC at all since it held it in some sort of “trust”. Hence the low asset recovery rate. Credibility of China and Chinese financial system was tarnished for a long time.

Last week also witnessed the first Chinese property company – Kaisa Group Holdings (1638 HK) – to default on offshore bonds held by foreign investors, ranging from BlackRock to Fidelity. Kaisa has total debt of around $5bn.

This news was followed by the $24bn reorganization of the business empire controlled by Asia’s wealthiest entrepreneur Li Ka-Shing.  The non-property assets of Li’s Cheung Kong (1 HK) and its subsidiary Hutchison Whampoa (13 HK) would be injected into a new company, Caymans-incorporated CK Hutchison (CKH). Property interests will go into another new Caymans-registered entity, Cheung Kong Property (CKP), which will seek a separate listing.

The “official” reason is said to eliminate the 23% valuation discount that the Cheung Kong stock has to bear with as a holding company of Hutchison. Under the restructuring plan, Cheung Kong shareholders will receive one CKH Holdings share for every Cheung Kong share, while CKH will offer Hutchison shareholders 0.684 CKH share for every Hutchison share. All eligible CKH shareholders will receive one CKP share for every CKH share. The share swap ratio puts Cheung Kong shareholders, including the Li family, at an advantage. Hutchison shareholders will get 31% less of the new entity of the future property and non-property arms than their Cheung Kong peers. The Li family will get a 30.15% direct ownership in both the property and non-property arms, instead of an indirect holding of Hutchison through Cheung Kong.

Noteworthy is that Hutchison could have sold its property business to Cheung Kong for the latter’s non-property assets. This could have been followed by a distribution of Hutchison shares held by Cheung Kong to Cheung Kong shareholders. In addition, Li’s controlled companies have been reducing their exposure to Greater China property, with Hutchinson Whampoa selling off its stake in Hutchinson Harbour Ring, which owns two properties in Shanghai, and other property assets in China. Coupled with the Kaisa default event, the strong actions appear to reflect his bearish outlook on the Greater China market, that something ominous could be imminent?…

Warm regards,

KB

The Moat Report Asia

www.moatreport.com

http://accountancy.smu.edu.sg/faculty/profile/108141/KEE-Koon-Boon

A new monthly issue of The Moat Report Asia is now available!

Access the in-depth idea presentation:

http://www.moatreport.com/members/

§  Our paid Members from North America, Europe, the Oceania and Asia include professional value investors with over $20 billion in asset under management in equities, some of the world’s biggest secretive global hedge fund giants, and savvy private individual investors who are lifelong learners in the art of value investing.

“Keeping Life Good At Home”: The Dream of “One India”

Q: “Ji, what motivates you? How did you push yourself over the years and not give up with all the problems and challenges?”

Mr. K: “Problems are part of life, whenever you do business. It will come to anybody who do business. Solve it and move forward. You keep on talking, there’s no solution. You need to keep moving forward. My motivation comes from the family, the support of the wife, and life being good at home was very important. Without that, you cannot do it. She didn’t push me. She kept life good at home and that’s what kept me going. No pushing. It’s the key to success, a good home environment.”

“Keeping life good at home”. This is a beautiful and fitting message for the New Year 2015 in India who is seeking to implement the uniform GST tax rate, with effective from April 1, 2016. The GST would replace more than a dozen taxes that increase incentives for corruption and offer the economy a boost of as much as 1.7%. Modi’s government had presented the uniform GST tax-rate proposal to the lower house in Delhi on Dec 18 last year and aims to pass the bill in the session of parliament beginning in Feb 2015. Since the GST unifies the states into a single landmass, into “One India”, inter-state movement will be seamless. By “keeping life good at home” with the various reforms and policies, companies which enjoy a pan-India manufacturing and distributing presence will reduce their logistics cost and stand to gain significantly in the domestic home market.

Can you guess who is Mr. K? Our latest monthly Moat Report Asia for January 2015 examines an Indian company established by Mr. K in 1988, now the #1 leader in the industry with a market share of 20% – and a beneficiary of the “One India” GST reform.

Led by Mr. K and his two sons who joined the business in 2000, the family business has transformed the industry in India with their vision, patient sacrifice and stable capital through long-term profound investments in building up the unique business model of loyal dealer network with over 10,000 point-of-sales, a pan-India manufacturing and distribution presence, superior design capability and production technology and marketing innovations, giving it a distinct competitive edge and premium pricing power over its peers. Thus, while its peers are impacted by the rising cost pressure, rupee volatility, and an uncertain business environment, the company went on to not only consolidate the fragmented industry but also successfully create a consumer ‘pull’ from catering to the aspirations of the consumers in the entire value pyramid with its quality product offerings. The company enjoys the highest brand equity in the industry and has consistently the highest ROA, ROE and profit margin, and the most efficient cash conversion cycle in the industry. Its Pan-India network means the company has the ability to move products quickest off shelves, at a rate equivalent to the size of 20 international football fields every day! The company has strong fundamentals with ROE at 26% and EBIT margins at 15+% that is far higher than its rivals’ 4-5% to support valuations.

Through shrewd capital allocation policy in reinvesting its profits back into widening the moat of the business, the company has grown its production capacity over 54-folds in a smart, asset-lighter way without blowing up its balance sheet and not raising any capital from the equity market since its 1988 IPO – by acquiring management control in efficient regional producers at a low capital cost which generated revenue from day one and serviced markets faster in selling with their own brand. With the plan to double production capacity in the next three years by Mar FY2018, and strong industry dynamics over the next 7-8 years supported by policies such as the GST reform, Swachh Bharat (Toilet for All by 2019) and “Housing for All by 2020”, the company’s mid- to long-term growth outlook is resilient and market value could potentially triple in 3-5 years. Mr. K’s family owns 52.1% of the company which is their flagship business vehicle.

Who is Mr. K and his listed family business?

Warm regards,

KB

The Moat Report Asia

www.moatreport.com

http://accountancy.smu.edu.sg/faculty/profile/108141/KEE-Koon-Boon

A new monthly issue of The Moat Report Asia is now available!

Access the in-depth idea presentation:

http://www.moatreport.com/members/

§  Our paid Members from North America, Europe, the Oceania and Asia include professional value investors with over $20 billion in asset under management in equities, some of the world’s biggest secretive global hedge fund giants, and savvy private individual investors who are lifelong learners in the art of value investing.

December is an unrelenting month – December last year took away from the world an accounting superhero, Professor Abraham Briloff. Right up until about a month before his death on Dec 12 at age 96, Abe was unrelenting in alerting Barron’s about some accounting fraud he had uncovered that was hidden in corporate America’s financial statements – a lifelong endeavor he persisted for 45 years since his enlightening “Dirty Pooling” article on July 15, 1968. When financial crisis strikes, Abe’s words become the Generally Accepted Accounting Principles. Even though Abe was legally blind, he could see clearly the accounting issues, having memorized pages of the company’s financials that had been read to him by his daughter Leonore or his grad students at City University of New York’s Baruch College. When asked about his thought process, the grandmaster said, “It begins with some sensitivity as to where the problem might be. Somehow, there’s a serendipity where I know that there’s an issue out there.” Abe elaborates his Process in a Barron’s interview:

“The numbers reverberate in my mind, and then I turn to Leonore and say, ‘Get for me the data in these areas,’ or ‘Read such-and-such to me from whatever document you might find.’ He records his thoughts on tape, on one of the several recorders that he keeps on the desk in his study, and then he reflects further. When he goes to bed, the numbers still dance in his mind, and he keeps a tape recorder beside his bed. It is as if he can see the numbers, much as Beethoven could hear the melodies even though deaf. As new numbers come in, he incorporates them into his thinking, to confirm or reject his original hypothesis. “Something hits. You say, ‘Why is it there?’ Or something that should be there, isn’t there,” he says. He performs the most critical calculations in his head.”

Abe’s heroic commitment to exposing accounting frauds has been a source of inspiration for us when crafting out Accounting Fraud in Asia, an official course in the Singapore Management University (SMU) degree curriculum that will be launched in January 2015. The course, which is focused on the capital markets perspective, is the first of its kind to be taught in universities in Singapore/Asia and worldwide and is open to all university students worldwide on global exchange programs with SMU. The course is conducted in an interactive session over 15 weeks. We shall focus on developing an interdisciplinary critical thinking and accounting Perspective with a real-world emphasis in the group and individual project writings, presentation and participation. Perspective has two definitions: (1) Context: A sense of the larger picture of the world, not just what is immediately in front of us; (2) Framing: An individual’s unique way of looking at the world, a way that interprets its events. With Perspective, we can discover leverage we didn’t know we had.

We have also started a simple website called “Asian Extractor: Unearthing Accounting Fraud in the Asian Capital Jungle” (www.AsianExtractor.com). Asian insiders Extract and expropriate wealth in artful accounting tunneling methods as opposed to western-style accruals-based earnings management. We attempt to Extract them out in the Asian capital jungle; akin to the Lotus who extracts mud out of her hollow stem and the stem grows up with determination, enabling the Lotus flower to blossom above the muddy water, rising above the defilement and remaining unstained and pure.

AsianExtractor will be a visible global platform for the students to showcase their talent and analysis and to contribute their findings and add value to the global business and investment community, just like Abe and his students. We hope the website will develop into a thought leadership platform on accounting fraud in Asia with analyses and opinions from the students and expert guest speakers in the course as well as from global experts. We are an admirer of the Institute of Design at Stanford in terms of its unique curriculum design as our benchmark and we strive to make improvements over time with your valuable feedback and comments. If you would like to contribute an article to this thought leadership platform on accounting fraud in Asia, please drop us an email at: asianextractor@gmail.com or bambooinnovator@gmail.com.

The weblink is the presentation materials for Week 1 (Jan 5-9, 2015) – Survival in the Asian Capital Jungle: Who Knows What When. From Week 2 (Jan 12-16, 2015) onwards, the presentation materials will stand in for the Bamboo Innovator Weekly Insight and be made available for our Moat Report Asia subscribers only.

Here’s wishing everyone a Blessed New Year 2015 ahead.

Warm regards,

KB

The Moat Report Asia

www.moatreport.com

http://accountancy.smu.edu.sg/faculty/profile/108141/KEE-Koon-Boon

A new monthly issue of The Moat Report Asia is now available!

Access the in-depth idea presentation:

http://www.moatreport.com/members/

§  Get The Moat Report Asia – a monthly in-depth presentation report of around 30-40 pages covering the business model of the company, why it has a wide moat and why the moat may continue to widen, a special section on “Inside the Leader’s Mind” to understand their thinking process in building up the business, the context – why now (certain corporate or industry events or groundbreaking news), valuations (why it can compound 2-3x in the next 5 years), potential risks and how it is part of the systematic process in the Bamboo Innovator Index of 200+ companies out of 15,000+ in the Asia ex-Japan universe.

§  Our paid Members from North America, Europe, the Oceania and Asia include professional value investors with over $20 billion in asset under management in equities, some of the world’s biggest secretive global hedge fund giants, and savvy private individual investors who are lifelong learners in the art of value investing.

“The impediment to action advances action. What stands in the way becomes the way.”

– Marcus Aurelius, last of the “Five Good Emperors”, in Meditations

“Most people would think that it has been one straight line to get to where we are today,” the dynamic founder of Myanmar’s #1 systems integrator said thoughtfully to our group. “Because of the banking crisis in Myanmar in 2003, we find ourselves in a situation whereby a substantial part of our revenue and operating cashflow disappear as our banking clients stopped their IT projects”.

The 2003 banking crisis in Myanmar saw the collapse of more than a dozen deposit-taking companies. Their owners had used depositors’ funds to build up their own diversified business interests. Depositors went unpaid and a panic ensued, resulting in a bank run – and an underdeveloped banking system with low trust amongst many depositors who remained wary of putting their hard-earned money in banks till today.

This leading technopreneur remarked evocatively: “Just imagine, overnight, you find yourself with more than half of your revenue gone. What would you do? We did not give up and we expanded our software and solution offerings to other industries that include retail and business enterprises. We emerged stronger from the crisis and our sales and firm value have since soared multiple-folds.”

This is one of the many positive uplifting entrepreneurial stories that we have carefully collected during our official study mission trip to Myanmar from 7 to 16 Dec. During the trip, our group are privileged to have the invaluable opportunity to learn the art of business strategy from visiting the leading companies in Myanmar where we had visited the factories and facilities of diverse industries, including having up-close-and-personal interactions with outstanding business leaders and top government officials.

Let’s face it, most of us are oftentimes paralyzed by the many obstacles that lie ahead of us. As we watch in awe as some seem to turn those very obstacles, weaknesses and misfortune into strength for themselves, we start to think: How do they do that? What’s the secret? Do they have a method and a framework for understanding, appreciating, and acting upon the obstacles life throws at them?

If so, this critical insight will have tremendous implications for value investors in Asia and emerging markets which are rocked by a meltdown in local currencies which hit a 14-year low against the US dollar last week and a potential prolonged economic and credit hangover that will carry forward into 2015. Emerging markets have collectively borrowed $5.7 trillion in US dollars, a massive credit risk weighing down on the emerging markets index which has tumbled 17% since Sep 3, pulled down by falling oil prices and debt concerns from Russia. It has been estimated that over $500bn of petrodollars a year are recycled back into the financial markets and their evaporation as a result of the plunge in oil prices has exacerbated the parched liquidity conditions in the credit markets. In an ominous parallel, the emerging market index fell almost 60% between Jul 1997 and Sep 1998, when oil prices tanked and emerging-market currencies began a freefall amid a Russian debt default. The shared component in the emerging market misery is economic recovery in the western developed markets that include a stronger US dollar and a new gold rush in the Silicon Valley.

As we ponder the entrepreneurial fundamentals of selected Asian innovators pitting against the fickle emerging market sentiments, we are reminded of Intel’s Andy Grove wisdom that “Bad companies are destroyed by crisis. Good companies survive them. Great companies are improved by them.” Myanmar’s #1 systems integrator was established in 1997, during the 1997/98 Asian Financial Crisis, as are half the companies in the Fortune 500 that were started during depressions or economic crises: FedEx (oil crisis of 1973), Charles Schwab (market crash of 1974-75), Microsoft (recession in 1973-75), Costco (recession in the late 1970s), Hewlett-Packard (Great Depression 1935), UPS and General Motors (panic of 1907), Fortune magazine (90 days after the market crash of 1929), P&G (panic of 1837), Coors (depression of 1873), LinkedIn (2002, post dot-com bubble) and so on.

During the study mission to Myanmar and over the decade plus in the Asian capital jungles, we find that selected Asian innovators are able to steal good fortune from misfortune because they had the ability to see obstacles for what they were, the ingenuity to tackle them, and the will to endure a world mostly beyond their comprehension and control.  They were busy existing in the present, dealing with the situation at hand, dealing with things as they happen. Importantly, they saw in each and every one of these obstacles as an opportunity to practice some virtue: patience, courage, grit, humility, resourcefulness, and creativity. Like oxygen to a fire, obstacles became fuel for the blaze that was their ambition. Every impediment only served to make the inferno within them burn with greater ferocity. Thus, The Obstacle Is The Way is undoubtedly the Phrase of the Year for these entrepreneurs and innovators. It is also the title to the profound book by Ryan Holliday who had apprenticed under Robert Greene, author of the 48 Laws of Power and Mastery which we recommended in our earlier articles and in the Value Investing Seminar 2014 in Trani, Italy.

Inspired by the book and by our experience in the study mission to Myanmar, we crystallized our insights into a framework about the 4Cs: (A) Continuity – Pursuing the dream, (B) Command and Control vs Freedom to act and adapt to the local market conditions, (C) Community and Connection: Uniting the people and being good partners, and (D) Culture of kindness, trust and cooperation to foster innovation and cultivate resilient growth.

We hope that this framework will also prove as a guide for value investing in Asia in 2015 in identifying and evaluating the type of unique business models which can grow resiliently and scale up in the turbulent and uncertain times ahead.

(A) Continuity – Pursuing the dream

<Article snipped>

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To prevent ourselves from becoming overwhelmed by the world around us and by the growing uncertainty in the investing environment, we can navigate the terrain with the phrase “The Obstacle is the Way”. We are inspired by the stories of John D Rockefeller and Thomas Edison in living up to the phrase:

Rockefeller: In his early working career, Rockefeller was caught in the Panic of 1857, a massive national financial crisis that saw businesses failed and the price of grain plummeted across the country, resulting in a recession that lasted for several years. Instead of lamenting his misfortune at this economic upheaval, Rockefeller eagerly observed the events that unfold as an opportunity to learn, watching what others did wrong. Rockefeller went on to seize advantage from obstacle after obstacle in his life, during the Civil War, the panics of 1873, 1907 and 1929.

Edison: In 1914, the factory of the legendary inventor was engulfed in fire and the cruel fire destroyed his life’s work. Instead of crying in sadness or yelling in anger, Edison told his 24-year-old son, “Go get your mother and all her friends. They will never see a fire like this again.” At the scene of the blaze, Edison was quoted in the New York Times as saying, “Although I am over 67 years old, I’ll start all over again tomorrow.” Edison stuck to his word and immediately began rebuilding the next morning, without firing any of his employees. Edison had lost $23m in today’s dollar in the fire, and this is not including years of priceless records and prototypes. After just three weeks, with a sizeable loan from his friend Henry Ford, Edison got part of the plant up and running again. His employees worked double shifts and set to work producing more than ever. Edison and his team went on to make almost $10 million four years later, in 1918.

The phrase “The Obstacle is the Way” serves to illuminate the mindset and driving force of selected wide-moat compounders who are able to create value in difficult times – and will be an incredible advantage for us in our own fight against Obstacles.

We like to wish our readers a Merry Christmas and a Blessed New Year 2015! Our monthly Moat Report will be out on in the week on 5 Jan. Thank you for your support all this while!

Warm regards,

KB

The Moat Report Asia

www.moatreport.com

www.bambooinnovator.com

PS1: We will be introducing Accounting Fraud in Asia as an official course in the Singapore Management University (SMU) degree curriculum that will be launched in January 2015. The course is the first of its kind to be taught in universities in Singapore/Asia and worldwide and is open to all university students worldwide on global exchange programs with SMU. We are proud to have our inaugural Teaching Assistants for the course: YEO Shan Rui, President of the SMU SMIF (Student Managed Investment Fund) and Sebastian SEOW Wei Han. Shan Rui has also contributed his first piece: Vincent Tan – The history and IPO of 7-Eleven Malaysia. We have loaded some articles on www.AsianExtractor.com to generate some discussion for the students in the course:

http://asianextractor.com/2014/12/20/sec-fines-baker-tilly-hong-kong-for-missing-red-flags-in-china/

SEC Fines Baker Tilly Hong Kong for Missing Red Flags in China

Discussion Questions:

(1) Are companies audited by Baker Tilly HK more prone to accounting fraud? What are the firm characteristics e.g. state-owned companies vs privately-owned enterprises? Are they from certain industries? Are they structured as offshore holding companies? Generate the list of Baker Tilly audit clients and do some analysis..

(2) Do different audit firms have different policy in their audit of related-party transactions of Asian/ Chinese companies?

(3) Why has US SEC struggled for years to obtain information for dozens of accounting fraud investigations at China-based companies?

http://asianextractor.com/2014/12/20/us-sec-cautions-companies-on-consolidation-analyses-using-vie-variable-interest-entity/

SEC Cautions Companies on Consolidation Analyses Using VIE (Variable Interest Entity)

Discussion Questions:

(1) Chinese ecommerce giant Alibaba uses the VIE structure. Given the “success” of Alibaba’s IPO, are VIEs necessarily bad i.e. are companies with VIE structure more prone to accounting fraud? What kind of companies tend to use the VIE structure? Generate a list of companies with VIE structure in different exchanges in US and Asia and do some analysis…

(2) How can the management abuse their application of “shared power” in consolidating VIE? What is the accounting policy take on discretionary changes in the exercise of this power?

We hope the website will develop into a thought leadership platform on accounting fraud in Asia with analyses and opinions from participants and expert guest speakers in the course as well as from global experts. We are an admirer of the Institute of Design at Stanford in terms of its unique curriculum design as our benchmark and we strive to make improvements over time with your valuable feedback and comments. If you would like to contribute an article to this thought leadership platform on accounting fraud in Asia, please drop us an email at: asianextrator@gmail.com or bambooinnovator@gmail.com.

PS2: Below is the short address made on 15 Dec by KB in the dinner event hosted and organized by Inter Group that marks the success and closure of Singapore Management University’s first official study mission trip to Myanmar. The special dinner event provides an extended platform for SMU student delegates to interact with business leaders.

Good Evening Mr Nick Nyi Nyi Htun, Jadyn, and the InterGroup team, our honorable host,

Distinguished Guests, Ladies and Gentleman,

During Singapore Management University’s official Study Mission trip, our students are privileged to have the invaluable opportunity to learn the art of business strategy from visiting the leading companies in Myanmar.

What really matters more than anything is character. The character of the people determines the quality of the institution. Strong institutions are about systems and people as much as new regulations and laws. We are grateful that our students are able to have up-close-and-personal interactions with outstanding business leaders of Myanmar. They represent the future of Myanmar with their strong sense of national pride and collective commitment that has inspired confidence in spite of – or because of! – the daunting challenges ahead.

Our delegate are most fascinated by the resiliency of the Myanmar people who are like the Bamboo which bend, not break, even in a storm that would snap the mighty resisting oak tree. It survives, therefore it conquers. And the Bamboo also represents the value of uprightness and the art of springing back after adversity: In winter the heavy snow bends and covers the bamboo, the bamboo patiently waits for the snow to melt down and then snaps back up tall again, brushing aside all the snow. And in the end, the bamboo stands tall, evergreen and beautiful.

Noteworthy is the invisible intricate underground root structure that makes the ground around a bamboo forest very stable – and make possible the flexibility and adaptability of the bamboo innovator to bend, not break, with the wind. To translate potential into sustainable growth requires the building of these intricate root-like institutional and market capacity and capabilities to manage the winds of opportunity – and potential risks – blowing in Myanmar.

Three of our SMU students – Alvina Ow Swee Ting, Ringo Tan Chuan Hong and Charles Chen Siyang – will represent our SMU delegate to present the findings and reflections from our study mission under the central theme of Sustaining Transformation in Myanmar. We hope that the findings and framework will be useful and practical in helping the global business community understand more about Myanmar.

This framework is about the 4Cs: (1) Continuity – Pursuing the dream, (2) Command and Control vs Freedom to act and adapt to the local market conditions, and (3) Community and Connection: Uniting the people and being good partners. We will reveal the fourth C at the end of their presentation. Following which, our SMU delegate will like to sing a few songs with meaningful lyrics to express our heartfelt thanks and blessings to the people of Myanmar. Let us now give a warm applause to Alvina, Ringo and Charles who will share with us their findings and personal reflections.

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The fourth C is Culture. The Culture of kindness, trust and cooperation to foster innovation and cultivate resilient growth. Kindness is like water nourishing the powerful roots of bamboo. Bamboos are found most abundantly along the waterways, among the rice paddies. A true test of kindness, which is harder than empathy towards failures, is joy at other people’s success as a result of doing the right things – a rare virtue that Buddhists call mudita. Kindness is also an inner revolution; as are reform and innovation. We are able to put less in our possession and more in people. The boundaries between us and others begin to merge, so that we feel engaged and committed as part of a whole in which it is possible to share resources, emotions and innovations.

With this four Cs completing the framework, we like to invite Professor Low Aik-Meng, who’s the founding pioneer of our University and the founding Dean of Students, to lead the students to come on stage to present a university gift to our honorable host and for us to begin our singing to the people of Myanmar to say a big thank you. The songs are “If We Hold On Together” and “This is Home”.

PS3: Below is an article that we shared with one of the entrepreneurs in Myanmar whom we believe has the potential to rise to become the wealthiest in the nation, much like Philippines’ Henry Sy of SM Investments (SM PM, MV $14.2bn) and SM Prime (SMPH PM, MV $10.9bn), and John Gokongwei of Universal Robina Corp (URC PM, MV $9.5bn) and JG Summit (JGS PM, MV $10.3bn).

3 December 2010

Bamboo Innovators in South Africa and Lessons for Asia

By KB Kee

“A business built on a deeper purpose may not dominate the economic landscape but it is a long-distance runner in it, outliving flashier outfits built on profit maximization”, ruminated South African Bamboo innovator Raymond Ackerman, who built Pick n’ Pay from four small stores in 1966 to a retail empire with sales of S$10 billion and listed on the Johannesburg Stock Exchange with a market capitalization of over S$4 billion. Ackerman was also rated by Financial Times as among the World’s Top 100 Most Respected Businessmen.

Ackerman recalled the ripple of disbelief among his classmates when his lecturer, Professor WH Hutt, later heralded as one of the “Economists of the Century” by the Wall Street Journal, opened their lesson with these words: “Most of you are here to make money, but you won’t. Not unless you have a moral mission”.

This view became the cornerstone of the Pick n’ Pay philosophy in how Ackerman builds and grows his business based on the principles of “consumer sovereignty” in the turbulent and complex environment of South Africa, as he tackled iniquitous cartels and break price monopolies to bring food and other goods at lower prices to the society. For instance, in the 1960s, whenever Ackerman tried to sell bread below the regulated price, he was warned that he would be fined ten rand for every cut-price loaf of bread he sold. He fought back by harnessing public outrage and the government had no choice but to allow retailers like Pick n’ Pay to sell bread at lower prices.

The late retail giant Sam Walton, whom the world’s greatest investor Warren Buffett felt was the greatest CEO of all time, was initially a discount retailer with no food department. Sam was searching for the best hypermarket format so as to make better things ever more affordable to people of lesser means  and he was inspired after touring Pick n’ Pay’s hypermarkets in South Africa. Sam replicated the idea in America and worldwide with a capable team and scalable infrastructure, resulting in Wal-Mart’s astounding multibagger success to over S$200 billion in market capitalization from its initial listing size in 1970 of S$40 million.

It is striking how these exceptional Bamboo Innovators in South Africa are able to integrate their business with a deep-seated desire to serve humanity in some meaningful way by bringing what belongs to the privileged for the masses to enjoy.

South Africa is the first country to bring the cellphone to the masses through prepaid billing. Cellphones were sold based on contracts all along and owing to the apartheid legacy, black people were not on the systems that checked bank accounts and creditworthiness, and hence could not sign up for mobile phone contracts.

Alan Knott-Craig, the former CEO of telecom operator Vodacom, had a “reckless” idea in prepaid billing, and launched the prepaid system in November 1996. Today, at least 90 percent of South African customers, or nearly 45 million users, are prepaid customers. The technology Vodacom developed was adopted worldwide and now serves more than 2 billion users internationally. Vodacom opened up the market to millions of people who would otherwise have been excluded.

Naspers CEO Koos Bekker brought pay TV to South Africa in 1984, the first country outside of America to have such entertainment, connecting millions to “where magic lives”, their famous slogan. Naspers is an international media conglomerate with a market capitalization of S$30 billion. Its pay TV platform, with flagship entertainment and sporting channels M-Net and SuperSport, has a subscriber base of 4 million homes in 48 African countries.

Amongst its international media businesses, Naspers has a 35 percent stake in HK-listed Tencent, the dominant instant messaging QQ platform in China for over 600 million users. Naspers reaped more than 60-fold returns from their 2001 investment as Tencent’s market capitalization surged to over S$60 billion presently since its listing size of S$1 billion in 2005. Naspers also has a 28 percent stake in Mail.ru, which in turn has around a 2.4 percent interest in Facebook and stakes in internet properties with tremendous marquee value such as Zynga and Groupon.

Ackerman also cautioned against the biggest temptation facing all entrepreneurs: Never treat your business as a personal piggy bank. “Many entrepreneurs, starry-eyed at the sight of cash flowing in, will rush out to buy themselves matching BMWs, with only a vague sense of the actual expenses that go into their business. Some even rationalizes that it is the owner’s right, after all the stress and strain of getting the business off the ground and keeping it afloat! The business should never be a vehicle to fund your lifestyle, but a healthy entity able to pay you a salary, no matter how meagre, with profits ploughed back into the business”, Ackerman said emphatically.

He added: “You have to exercise enormous self-discipline, particularly if it is a cash-rich business, because the temptations are very real to see this as your personal honeypot. But it is the kiss of death for anyone with a long-term view to building a strong business. It is also thoroughly demotivating for employees. Whether you are working for a large or small business, there’s nothing worse than watching owners siphon off the profits. Your business is a third party, separate from you, and the profits belong to the business. Do this, and you will have created a clear moral universe for your employees to work within, with a far healthier business as a result.”

All of these extraordinary Bamboo Innovators have something in common – they witnessed first-hand the problems that beset the masses and wanted to build a business to provide useful products and services. And they are not contented to stop at $10m, $100m, or even $1 billion, like most businesspeople who rush to buy fancy property and cars for themselves. These South African Bamboo Innovators want to build and scale their businesses so that they can give more. Only when we have the desire to give, then can we want to persevere in building something meaningful. This urge to build in order to give is the magnetic north to scale a Bamboo Innovator and they work obsessively to realise this vision.

Bamboo Innovators are alert to existing paradigms of how things ought to function and behave in the marketplace. It is this alertness that leads to their discovery through their strong conviction and belief that they can do it significantly better – and also the real reason why they build their business with a long-term view, rather than to use the business as a vehicle for personal enrichment.

Just like how Sam Walton “discovers” the anomaly of retailers overcharging the customers and how customers are underserved – and seeks to correct things by being a champion of the customer with Wal-Mart’s “Everyday Low Prices” by passing along cost savings back to the customers.

The vision Ackerman has for his country is inspiring and uplifting and an ideal worth fighting for: “Even in our darkest hour, I never lost my faith that South Africa would one day emerge from its long apartheid night into a dawn filled with vibrant promise.”

A new monthly issue of The Moat Report Asia is now available!

Access the in-depth idea presentation:

http://www.moatreport.com/members/

§  The weekly insight is a teaser into the opportunities – and pitfalls! – in the Asian capital jungles.

§  Get The Moat Report Asia – a monthly in-depth presentation report of around 30-40 pages covering the business model of the company, why it has a wide moat and why the moat may continue to widen, a special section on “Inside the Leader’s Mind” to understand their thinking process in building up the business, the context – why now (certain corporate or industry events or groundbreaking news), valuations (why it can compound 2-3x in the next 5 years), potential risks and how it is part of the systematic process in the Bamboo Innovator Index of 200+ companies out of 15,000+ in the Asia ex-Japan universe.

§  Our paid Members from North America, Europe, the Oceania and Asia include professional value investors with over $20 billion in asset under management in equities, some of the world’s biggest secretive global hedge fund giants, and savvy private individual investors who are lifelong learners in the art of value investing.

Can You Guess This Asian Wide-Moat Company?

Even a Billionaire Makes “Mistake” – and Quickly Rectifies It!

In March 2013, a secretive Southeast Asian billionaire made a “mistake” – he pulled out of a $750m investment to acquire a 30% stake in a leading Asian-listed company whose share price later shot up 240%. He managed to paint a deal to acquire a 15% stake instead in February 2014 in the company whose share price subsequently doubled.

We are a long-time admirer of this low-profile Bamboo Innovator who picked up his knowledge in the business when working as an apprentice to support the family while his mom did laundry and his sister sold Teochew “soon kweh”, a traditional street food. The tycoon started his business in 1955 and his entrepreneurial talents and capital allocation skills is impressive in transforming his private family business from a product supplier to service provider by continuously integrating modern technology into the business model and he sets an exemplary example for Asian entrepreneurs.

This billionaire’s listed investment and family business is a beneficiary of the sharp fall in crude prices to below $70 per barrel in recent months from an oversupply situation which has resulted in a positive tailwind in lower raw material costs to boost profit margins for the industry that the company is operating in. Saudi Arabia’s decision to refuse to cut output on Nov 27 signals its intent to keep oil prices lower for longer to get rid of its shale rivals in a who-blinks-first brinksmanship.

Our latest monthly Moat Report Asia for December examines another North-Asian entrepreneur Mr. C who started a similar business in 1951, four years earlier than the Singapore tycoon. This Asian-listed company has since grown to become the #1 company in its home market with domestic market share leadership of 30% and 50% in the consumer product and industrial product respectively under its own brand. The intangible asset in the trust and support that Mr. C’s family business enjoys in the community amongst its customers and long-term business partners has resulted in the listed company to generate free cashflow for 19 consecutive years since 1995, even during the 1997/98 Asian Financial Crisis and 2007/09 Global Financial Crisis.

Strikingly, Mr. C’s listed family business has the highest reward/risk ratio in the industry that is riding the tailwind of sustainable low feedstock costs. Its EV/EBITDA of 8.9x is substantially lower than its Indian rivals 24.7-33.9x and US peers 13.4-18.1x. It has the lowest Price/book value at 1.76x, substantially lower than its Indian rivals 10.9-15.5x and US peers 6.3-13.1x. Its short-term downside is protected by its healthy balance sheet with net cash (~13% of its market value) and an attractive dividend yield of 5.3%.

Mr. C was so passionate towards his work that he was still working just a day before he was hospitalized when he fell sick and passed away suddenly in 2006. However, this has also resulted in succession issues as the founder has not named any successor at that time and there was some internal family conflict. Mr C’s second son took over the leadership helm. The company received takeover offers from both its giant US rival and domestic industrial customer when Mr. C passed away but the controlling family rejected the offers.

Since the company managed to resolve its internal family conflicts in a saga that lasted nearly three years by mid 2009, profits are up 83% in four years between FY10 and FY13 and long-term growth initiatives are executed, including introducing service innovation, launching innovative new products and making bolt-on acquisition in US. Yet, the company has lagged behind significantly in share price performance both in the longer-term (last 5 years) and recently in the past 3 months to a year as compared to its peers. With the renewed focus in service innovation in its domestic market and strong growth momentum in its overseas development strategy in China and Vietnam, the company could potentially double its profits in 3-5 years, sparking a potential doubling in share price.

Underlying the company’s unmatched wide-moat distribution franchise that resulted in its domestic market share leadership is the corporate culture that takes pride in service excellence for its customers. The culture is fostered by the founder Mr. C who was passionate about delivering the best product and service because he understood keenly the frustrations, struggles and challenges of the customer, a role he started out when Taiwan was under Japanese rule. Mr. C had delivered one unit of the product to a customer by long-distance taxi after receiving a call from the customer when the day has closed, as a demonstration of customer service. This spirit of service excellence has been carried on throughout the years and is rare – and therefore valuable – in an Asian company.

When asked what is his guiding philosophy all these years in conducting business and life, Mr C’s second son commented: “It is important to bear compassion in mind and to do good deeds, which are beneficial to everyone.”

Who is Mr. C and his listed family business?

Warm regards,

KB

Managing Editor

The Moat Report Asia

www.moatreport.com

SMU: http://accountancy.smu.edu.sg/faculty/profile/108141/Kee%20Koon%20Boon

PS: We will be traveling away from 7 Dec till 16 Dec on the SMU Accounting Study Mission to Myanmar, which is an official course in the university curriculum. We have carefully researched and arrived at a list of outstanding companies for our visits. Our group of students will learn business strategies from leaders of successful companies and institutions. We will resume our Weekly on 22 Dec. And we will be back in 2015 with unique value-added content from Accounting Frauds in Asia, an official course in the SMU curriculum that we will be teaching in Jan 2015.

A new monthly issue of The Moat Report Asia is now available!

Access the in-depth idea presentation:

http://www.moatreport.com/members/

The Urgency for a Composite Measure to Detect Accounting Tunneling Fraud in Asia

“This is a huge international scandal,” Wang Donglei, the newly-appointed chief executive of China’s largest lighting and energy-saving lamp manufacturer, roared at a conference call on last Monday 17 Nov about the accounting fraud committed by the firm’s founder and controlling owner. “These banks misled the company and investors with false information. They did illegal things. These are major banks listed in Hong Kong. The embezzlement is being investigated by Chinese police.”

Last Monday is also the opening day of the much-anticipated Shanghai-Hong Kong Stock-Connect “through-train” door, creating direct access for foreign investors to one of the largest stock markets in the world with a combined value of $5.6tr. By expanding beyond qualified foreign institutional investors and sucking in new investment into Shanghai-listed stocks, the Connect was supposed to lower borrowing costs for mainland companies.

Could the prevalence of accounting fraud put the Connect at risk? Through the cases that follow, value investors need to be aware of a particularly brazen form of accounting fraud in which controlling owners use intercorporate loans to siphon off or tunnel out cash. Similarly, in Australia, intercorporate loans helped to facilitate the building (and later collapse) of the Alan Bond empire when the accounting fraud unravel. Descriptive cases detailing chronological events can inform about the fraudulent accounting acts after they happened but are inadequate in staying ahead of the devil who will invariably develop more sophisticated methods to escape detection. Thus, value investors need to out-think the devil – by first going back in time eight years ago to Nov 7, 2006 to understand the importance of the “Eight-Ministry Joint Announcement” that managed to curb accounting tunneling fraud, albeit for a short-while – and importantly, how controlling owners adapted the rule to continue their expropriation acts. Importantly, we spell out the urgency and opportunity for top accounting researchers-practitioners and regulators to develop a composite measure to detect tunneling acts to alert and prevent “live” cases of corporate abuse instead of fighting fire with “forensic accounting” of “dead” companies in which the harm had been done. But first, let’s get back to the recent cases of accounting fraud and examine their hidden footnotes.

NVC Lighting (2222 HK) – Stock Price Performance, 2010-2014

Wang alleged that Wu Changjiang, the founder and former CEO of NVC Lighting (2222 HK, MV $709m) whom he had ousted in August, had embezzled funds totalling RMB623m ($101.7m) on behalf of a company subsidiary. Employees of four leading Chinese banks – Bank of China (BOC), ICBC, China Construction Bank (CCB), Minsheng Bank – who “conspired in the crime of diverting and defrauding” the company’s funds were also under police investigation. NVC stock has been suspended since 11 Aug when Wu was expelled on 29 Aug from the company. NVC’s products are said to be used in the 2008 Beijing Olympics and 2010 Shanghai World Expo, and Wu is also a prominent entrepreneur featured by BBC, thus attracting reputable investors including private equity firm SAIF Partners, Goldman Sachs and French electrical systems giant Schneider Electric (SU EN, MV $46.7bn) when it was listed in May 2010 raising $196m in a deal underwritten by Goldman Sachs and HSBC. Schneider had invested HK$1.27bn ($163m) in Jul 2011 for a 9.1% stake in NVC.

In the week before the official launch of the Stock Connect, Wison Engineering Services (2236 HK, MV $450m) saw its share price plunged by nearly 60% in a day when its suspension for over a year was lifted on 12 Nov. Wison is a vast engineering-services empire controlled by its founder and billionaire Chairman Hua Bangsong, one of Chinese richest man. Wison builds refineries and chemical plants for domestic and international oil companies that include PetroChina and BASF. Wison was said to have obtained China’s highest certification to undertake petrochemical engineering work in 2007 when it bought a licensed, but near-bankrupt, quasi-government institute in Henan province. The 48-year old billionaire has not been seen since he was detained by Chinese investigators in Aug on bribery charges. Since the arrest, the company warned investors that it could post a “significant loss” for 2013 and might default on bank loans that total around $215m. Wison had earlier raised $195m in its IPO in Dec 2012. Similarly, when the billionaire chairman of Agile Property (3383 HK, MV $2bn) was taken into custody at end Oct by authorities, the disclosure was a shock to Western banks that had lent money to the company.

Wison Engineering Services (2236 HK) – Stock Price Performance, 2012-2014

Underlying the accounting frauds at NVC, Wison etc is the use of intercorporate loans to “tunnel out” cash and assets from the firm. During 1996-2006, tens of billions in RMB were siphoned from hundreds of Chinese firms by controlling shareholders. Typically reported as part of “Other Receivables”, these intercorporate loans did not …

<Article snipped>

As we have discussed, intercorporate loans classified under “Other Receivables” have shifted to other accounts in disguised forms that include … Thus, even though the income statement, balance sheet and even operating cash flow may appear healthy, the cash and assets are already tunnelled out and propping acts are continuously fashioned to draw in external funds and cash inflow to carry on the accounting charade. The different legal systems between Hong Kong and China create additional opportunities for expropriation by companies that can shift assets across the border, because rulings by courts in Hong Kong are not enforceable in the mainland. And the Connect could potentially exacerbate the propping-tunneling problem. Thus, there is a sense of urgency to develop a composite measure that captures the true “Other Receivables” that has artificially inflated revenue and earnings.

The tunneling problem in China and Asia has stubborn roots. Until these root tensions are fully addressed, insider tunneling will pose an ongoing challenge to reform in China and the seemingly pretty-looking financial ratios and accounting numbers at the typical firms are potentially propped up to suck in capital for subsequent tunneling acts.

Warm regards,

KB

Managing Editor

The Moat Report Asia

www.moatreport.com

SMU: http://accountancy.smu.edu.sg/faculty/profile/108141/Kee%20Koon%20Boon

To read the exclusive article in full to find out more about the story of NVC and Wison and the accounting and economics of tunneling that can provide an important organizing framework for value investors to navigate the Asian capital jungles, please visit:

·        The Urgency for a Composite Measure to Detect Accounting Tunneling Fraud in Asia, Nov 24, 2014 (Moat Report Asia, BeyondProxy)

A new monthly issue of The Moat Report Asia is now available!

Access the in-depth idea presentation:

http://www.moatreport.com/members/

§  The weekly insight is a teaser into the opportunities – and pitfalls! – in the Asian capital jungles.

§  Get The Moat Report Asia – a monthly in-depth presentation report of around 30-40 pages covering the business model of the company, why it has a wide moat and why the moat may continue to widen, a special section on “Inside the Leader’s Mind” to understand their thinking process in building up the business, the context – why now (certain corporate or industry events or groundbreaking news), valuations (why it can compound 2-3x in the next 5 years), potential risks and how it is part of the systematic process in the Bamboo Innovator Index of 200+ companies out of 15,000+ in the Asia ex-Japan universe.

§  Our paid Members from North America, Europe, the Oceania and Asia include professional value investors with over $20 billion in asset under management in equities, some of the world’s biggest secretive global hedge fund giants, and savvy private individual investors who are lifelong learners in the art of value investing.

Buffett’s (Non)Cash-Hitter and the Wide-Moat Asian Beauty Creator

“Instead, our problem has been that we own a truly marvellous collection of businesses, which means that trading away a portion of them for something new almost never makes sense. An example from sports will illustrate the difficulty we face: For a baseball team, acquiring a player who can be expected to bat .350 is almost always a wonderful event — except when the team must trade a .380 hitter to make the deal. Because our roster is filled with .380 hitters, we have tried to pay cash for acquisitions, and here our record has been far better.”

– Buffett in his 1997 Annual Letter to Shareholders

“I will be on the phone and out there on a regular basis to convince them that we’re still a very good investment.”

– P&G’s CEO A.G. Lafley at the analyst meeting after the Duracell divestment to Buffett’s Berkshire Hathaway who paid for the deal using P&G shares instead of cash

Is Buffett partly defeated by the “Water Sleeping Pack” and “Cushion Compact” when he signaled that P&G (PG US, MV $238bn) is possibly overvalued by using $4.7bn worth of its stock to acquire P&G’s Duracell business into Berkshire Hathaway (BRK/A, MV $358bn) despite having accumulated a cash hoard of over $62 billion?

While the billion-dollar tax savings is an important factor in the deal since BRK’s cost basis of P&G was $336m and corporate capital gains are taxed at 35%, the beauty engine behind P&G’s growth, led by the billion-dollar Japanese cosmetics brand SK-II, looks to have slowed down. P&G’s beauty business contributed 24% and 23% of sales and earnings respectively in FY2014, flat since 2011 and down from 30-31% in 2007. In Korea, one of the largest beauty markets in Asia, the import of Japanese cosmetics had plunged over 22% since 2012 and SK-II is one of the brands hit hardest. SK-II is considered a must-have item among adult career women despite the relatively high prices.

Since the Fukushima nuclear incident in Mar 2011, savvy Korean and Chinese women have increasingly stopped using Japanese cosmetics due to safety concerns. The Kanebo incident in 2013 had also shattered some confidence after its skin-whitening products left ugly blotches on the faces of over 15,000 customers. Kanebo is Japan’s second-largest cosmetics firm with more than a century old history and was acquired in Feb 2006 by Kao Corp (4452 JP, MV $20bn) after the infamous Kanebo/PwC-ChuoAoyama accounting fraud in 2004-05 that was comparable to the Enron scandal in size and social impact. Amid falling sales in Korea, Japanese cosmetics firm Orbis (4927 JP, MV $2bn) has shut its Korean office in Feb this year. Japanese brand DHC has closed over 10 outlets in Korea.

The losers are Japanese cosmetics and P&G’s SK-II. The winner can be found in visa-free Jeju Island, 60 miles off the southern coast of South Korea. 2.3 million Chinese tourists have stomped the island this year, up by nearly 50% a year ago. At the Shilla Duty Free Jeju, the island’s largest duty-free store owned by Hotel Shilla (008770 KS, MV $3.3bn), they are snapping up Korean cosmetics that include the “Water Sleeping Pack”, a gel-like nighttime facial moisturizer and one of the hottest cosmetic products under the brand Laneige that is owned by Korea’s largest cosmetics maker AmorePacific Corp (090430 KS, $11.8bn) and the holding company AmorePacific Group (002790 KS, MV $8.1bn). Another hugely popular product is the world’s first “cushion compact”, a mixture of colored foundation, sunscreen and moisturizer that users apply by touching a foam pad to a spongy, liquid-filled air cushion that blocks UV rays and covers imperfections naturally. Unlike BB cream, it can be reapplied throughout the day. Developed by AmorePacific’s research labs in 2008, women around the world have snapped up more than 30 million of them. AmorePacific reported 1H14 duty-free sales in South Korea to customers from China, Taiwan and Hong Kong surged 184% versus 1H13. Korean cosmetics are arguably the hottest category in travel retail worldwide. AmorePacific has also entered the global duty-free market since May 2010 in Singapore’s Changi Airport Terminal 3 with the Laneige shop.

AmorePacific Group (KOSPI: 002790 KS) – Stock Price Performance, 1995-2014

Value investors in Asia cannot look purely at quant “valuation” metrics since many business models are “permanently impaired”. Once-successful “Stage 1” entrepreneurs have scaled their companies by multiple-folds to say under a billion dollar in market cap in the past decade. But as a result of them mishandling risks, or preventing them in the first place through business model design, the companies fail to make the successful transition from a billion to $10bn in market value and are stuck. Often, these successful, achievement-oriented entrepreneurs start to “stray” as they find it easier to seek “growth” by engaging in private business interests outside of the listed vehicles, particularly in property development. Thus, under KB Suh’s leadership, AmorePacific is an exemplary example of a Bamboo Innovator who has been able to stay focused and give a good fight to the resourceful MNCs.

We often wondered aloud and lament at the low valuations in Asia as compared to the West. Alfred Chandler’s 1977 Pulitzer-Prize masterpiece, The Visible Hand: The Managerial Revolution in American Business, offered timeless practical insights and fundamental lessons for diligent value investors to stay ahead of the curve in Asia, uplifting us beyond the unsustainable realm of trading in and out and manipulating share prices and volumes in syndicates. Chandler narrated the emergence in 19^th century America, the age of robber barons, of firms which transform themselves by “organizational innovation” and “managerial innovation” to generate and sustain competitive advantage – to become Bamboo Innovators like AmorePacific.

Besides GE in 1890s…

<Article snipped>

Warm regards,

KB

Managing Editor

The Moat Report Asia

www.moatreport.com

SMU: http://accountancy.smu.edu.sg/faculty/profile/108141/Kee%20Koon%20Boon

 To read the exclusive article in full to find out more about the story of AmorePacific and KB Suh’s leadership, and Alfred Chandler’s business wisdom for value investors in Asia, please visit:

·        Buffett’s (Non)Cash-Hitter and the Wide-Moat Asian Beauty Creator, Nov 17, 2014 (Moat Report Asia, BeyondProxy)

 A new monthly issue of The Moat Report Asia is now available!

Access the in-depth idea presentation:

http://www.moatreport.com/members/

“Bamboo Innovators bend, not break, even in the most terrifying storm that would snap the mighty resisting oak tree. It survives, therefore it conquers.”

• The weekly insight is a teaser into the opportunities – and pitfalls! – in the Asian capital jungles.
• Get The Moat Report Asia– a monthly in-depth presentation report of around 30-40 pages covering the business model of the company, why it has a wide moat and why the moat may continue to widen, a special section on “Inside the Leader’s Mind” to understand their thinking process in building up the business, the context – why now (certain corporate or industry events or groundbreaking news), valuations (why it can compound 2-3x in the next 5 years), potential risks and how it is part of the systematic process in the Bamboo Innovator Index of 200+ companies out of 15,000+ in the Asia ex-Japan universe.
• Our paid Members from North America, Europe, the Oceania and Asia include professional value investors with over $20 billion in asset under management in equities, some of the world’s biggest secretive global hedge fund giants, and savvy private individual investors who are lifelong learners in the art of value investing.

Buffett’s Van Tuyl Auto Dealership: Starfish Vs Spider and Any Wide-Moat Asian Starfish?

“Well, Larry Van Tuyl talked to me six or seven years ago. I understand the business and I think that it is a decent business overall and I think the way Larry runs it is extraordinary. He has these partners in 78 dealerships and so he works on a partner basis. He’s got a terrific record over the years, and you know, it is something that we will own for 100 years. It really fits Berkshire – it’s the kind of business we can expand a lot because there are 17,000 dealers in the country and we are buying 78 of them through this means. So we will get a lot of opportunity to expand the business. This will be a big business for Berkshire. The Van Tuyl Group fits perfectly into Berkshire Hathaway from both a financial and cultural viewpoint. Larry Van Tuyl along with his father, Cecil, spent decades building outstanding dealerships operated by local partners. The Van Tuyl Group enjoys excellent relations with the major auto manufacturers and delivers unusually high volumes at its 78 locations.”

– Warren Buffett commenting on Berkshire Hathaway’s acquisition of Van Tuyl Group, the fifth largest auto dealership firm in the U.S. with $8 billion in sales, at an undisclosed price estimated at around $3 billion

“One thing that business, institutions, governments and key individuals will have to realize is spiders and starfish may look alike, but starfish have a miraculous quality to them. Cut off the leg of a spider,  you have a seven-legged creature on your hands; cut off its head and you have a dead spider. But cut off the arm of a starfish and it will grow a new one. Not only that, but the severed arm can grow an entirely new body. Starfish can achieve this feat because, unlike spiders, they are decentralized; every major organ is replicated across each arm.”

– Rod Beckstrom and Ori Brafman in their 2008 book “The Starfish and the Spider: The Unstoppable Power of Leaderless Organizations”

Starfish and Spiders seem to have crawled over the phenomena from Hong Kong’s “leaderless” protests to Buffett’s purchase of Van Tuyl’s network of 78 auto dealers, most of them located in the Southwest and Midwest.

Using the metaphor of “Spider” to depict traditional, top-down organizations and the “Starfish” to represent groups that lack structure, leadership and formal organizations, authors Rod Beckstrom and Ori Brafman in their book “The Starfish and the Spider: The Unstoppable Power of Leaderless Organizations” presented a thought-provoking view on how “Spider” organizations are increasingly being challenged and defeated by the “starfish”. Decentralized organizations exploiting strong networks are creating a wide-moat competitive advantage over conventional, centralized operations and they are incredibly resilient. Power and knowledge is disseminated across the “starfish” organization, and individual units can respond quickly to the increasingly complex internal and external forces of today.

Van Tuyl has a unique operating structure in which general managers of the individual dealerships typically retain a stake in their local business. The Van Tuyls commented: “I believe in people, people, people. There is no substitute for good people who really care and do a good job. We cut all of our people in on ownership because we believe that’s the way to go. We’re waiting to get more guys ready for general manager and partner. If they’re part owner, they’re going to look after business a little bit better.” Thus, the starfish organizations like Van Tuyl recognize that in today’s fast-changing and competitive environment, it’s the folks on the ground who have the best real-time information on how the battle is shaping up. They build an environment that respects their opinion, which seeks to make sure they understand the mission, and simultaneously empowers them to take the fight to the enemy in a way that optimizes their chances of success in whatever conditions they might find themselves.

Because each of Van Tuyl’s 78 dealerships is itself a partnership, a separate legal entity, like a starfish, the details of Berkshire’s acquisition took many months. Buffett added: “I like the Van Tuyl people enormously. But if I had had to deal with the contract’s complications, I probably wouldn’t have lasted it out.” The accounting for partnerships and joint ventures is also complicated by the IFRS 11 Joint Arrangements accounting standard. Under the US GAAP, JVs are accounted for using the equity method. Before IFRS 11, JVs may be accounted for under either the equity method or proportional consolidation but now IASB requires the use of equity method to bring about comparability of financial statements on a global basis.

<Article snipped>

“It’s easy to mistake starfish organizations for spiders,” the authors warn. Both have the appearance of multiple “legs” or divisions/units. So what are the distinctive characteristics of these “starfish”? There are five legs to a decentralized organization that can help it take off: (1) circles, (2) the catalyst, (3) the pre-existing network, (4) an ideology, and (5) a champion. Circles are essentially independent, autonomous groups that function on the basis of some implicit norms. The catalyst is the person who initiates a circle and then cedes control to its members, developing the idea, sharing it with others, and leading by example. Ideology is the glue that holds people together within such circles. Without access to the culture of trust prevalent in a pre-existing network, it is almost quixotic to attempt to build a decentralized organization. There is a champion who promotes the idea relentlessly. Instead of command and control through rational, powerful, directive instruments to organize and bring about order, the catalyst is a peer connecting people, who show: a genuine interest in others, a desire to help, a tolerance for ambiguity, and the ability to map new connections, to meet people where they are, to inspire others, to let go.

So is the starfish really undefeatable? The starfish can disintegrate quickly once the indestructible intangible ideology or trust is weakening. For instance, if the HK student protesters start to be aware that their actions have caused tremendous distress to the livelihoods and rights of the ordinary citizens that they are fighting for, confusion strikes the starfish about the legitimacy of its ideology and the terrifying strength starts to fade away. Similarly, the introduction of wealth and tangible rules and rights into the starfish may disperse the power of the starfish. The U.S. government finally bested the Apaches, for instance, when it provided its leaders with cattle, a form of wealth that reshaped the amorphous, nomadic tribes into easily manageable hierarchies. As the authors put it, “The moment you introduce property rights into the equation [be they intellectual, physical, or otherwise], everything changes: The starfish organization turns into a spider.”

Having got a clearer understanding about starfish organizations, are there any Asian starfish? From our Bamboo Innovator Index of 200+ companies, we think … have qualities of the starfish just like Van Tuyl, Jim Pattinson Auto and O’Reilly Automotive.

Asian Wide-Moat Starfish #1 and #2 – Stock Price Performance

<Article snipped>

********

“When you give people freedom, you get chaos, but you also get incredible creativity”. Starfish organizations are incredibly resilient and powerful because they work on the fundamental premise that their employees and business partners are good, can be trusted and wish to contribute. However, the powerful forces of the starfish can be abused like in the case of the “leaderless” terrorist networks al-Qaeda and ISIS. German philosopher Friedrich Nietzsche said, “One must still have chaos in oneself to be able to give birth to a dancing star.” To this, we add, “One must cultivate ‘emptiness’ as a Bamboo Innovator to be able to give birth to a resilient and positive dancing Starfish.”

Warm regards,

KB

Managing Editor

The Moat Report Asia

www.moatreport.com

SMU: http://accountancy.smu.edu.sg/faculty/profile/108141/Kee%20Koon%20Boon

To read the exclusive article in full to find out more about the story of the wide-moat starfish business model and companies in Asia, please visit:

• Buffett’s Van Tuyl Auto Dealership: Starfish Vs Spider and Any Asian Starfish? Oct 6, 2014 (Moat Report Asia, BeyondProxy)

“In business, I look for economic castles protected by unbreachable ‘moats’.”

– Warren Buffett

The Moat Report Asia is a research service focused exclusively on competitively advantaged, attractively priced public companies in Asia. Together with our European partners BeyondProxy and The Manual of Ideas, the idea-oriented acclaimed monthly research publication for institutional and private investors, we scour Asia to produce The Moat Report Asia, a monthly in-depth presentation report highlighting an undervalued wide-moat business in Asia with an innovative and resilient business model to compound value in uncertain times. Our Members from North America, the Nordic, Europe, the Oceania and Asia include professional value investors with over $20 billion in asset under management in equities, secretive global hedge fund giants, and savvy private individual investors who are lifelong learners in the art of value investing.

Learn more about membership benefits here: http://www.moatreport.com/subscription/

• Individual subscription at $1,994 per year:

https://www.moatreport.com/individual-subscription/?s2-ssl=yes

• Institutional subscription at $5,964 per year: https://www.moatreport.com/institutional-subscription/?s2-ssl=yes

The Moat Report Asia Members’ Forum has been getting penetrating quality dialogues from our subscribers.Questions range from:

• The nuances of internal dealings in Asia, including the case discussion of the recent deal in which HK billionaire’s Lee Shau-kee Henderson Landacquiring Towngas or Hong Kong & China Gas (3 HK) from his family holdings, seemingly déjà vu from the early Oct 2007 transaction when the market peak.
• The case of F&N Singaporespinning out its property unit FCL Trust and getting “free” special dividend-in-specie and the potential risk in asset swap restructuring to deleverage the hidden debt in the entire Group balance sheet.
• The dilemma of whether to invest in a Southeast Asian-listed company and hidden champion with a domestic market share of 60% due to family squabbles and a legal suit over the company’s ownership.
• Discussion of the wise and thoughtful 107-year-old Irving Kahn’s investment into a US-listed but Hong Kong-based electronics company with development property project in Shenzhen’s Qianhai zone and the possible corporate governance risks that could be underestimated or overlooked, as well as their history of listing some assets in HK in 2004.. This is also a case study of “buy one get one free” in John’s highly-acclaimed book The Manual of Ideasin which the “free” property is lumped together with the (eroding) core business to make the combined entity look cheap and undervalued. What are the potential areas that value investors need to watch out for when adapting the SOTP (sum-of-the-parts) valuation method in Asia?
• And many more intriguing questions.

Do find out more in how you can benefit from authentic and candid on-the-ground insights that sell-side analysts and brokers, with their inherent conflict-of-interests, inevitable focus on conventional stock coverage and different clientele priorities, are unwilling or unable to share. Think of this as pressing the Bloomberg “Help Help” button to navigate the Asian capital jungle. Institutional subscribers also get access to the Bamboo Innovator Index of 200+ companies and Watchlist of 500+ companies in Asia and the Database has eliminated companies with a higher probability of accounting frauds and  misgovernance as well as the alluring value traps.

Our 9th workshop will be sometime later in the year.

Thank you for your support all this while!

Warm regards,

KB Kee

Managing Editor

The Moat Report Asia

Singapore

Mobile: +65 9695 1860

A Service of BeyondProxy LLC

1608 S. Ashland Avenue #27878

Chicago, Illinois 60608-2013

Other offices: London, Singapore, Zurich

KB Kee has been rooted in the principles of value investing for over a decade as an analyst in Asian capital markets. He was head of research and fund manager at a Singapore-based value investment firm. As a member of the investment committee, he helped the firm’s Asia-focused equity funds significantly outperform the benchmark index. He was previously the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company.

He holds a Masters in Finance and degrees in Accountancy and Business Management, summa cum laude, from Singapore Management University (SMU) and had also published articles on governance and investing in the media, as well as published an empirical research paper Why ‘Democracy’ and ‘Drifter’ Firms Can Have Abnormal Returns: The Joint Importance of Corporate Governance and Abnormal Accruals in Separating Winners from Losers in the Special Issue of Istanbul Stock Exchange 25^th Year Anniversary Best Paper Competition,Boğaziçi Journal, Review of Social, Economic and Administrative Studies, Vol. 25(1): 3-55. KB has also presented his thought leadership as a keynote speaker in global investing conferences. KB has trained CEOs, entrepreneurs, CFOs, management executives in business strategy, value investing, macroeconomic, industry trends, and detecting accounting frauds in Singapore, HK and China, and had taught accounting at the SMU where he is currently an adjunct lecturer.

P.S.2  Why do I care so much about doing The Moat Report Asia for you?

My personal motivation in embarking on this lifelong journey has been driven by disappointment from observing up close and personal the hard-earned assets of many investors, including friends and their families, burnt badly by the popular mantra: “Ride the Asian Growth Story!” I witnessed firsthand the emotional upheavals that they go through when they invest their hard-earned money – and their family’s – in these “Ride The Asian Growth Story” stocks either by themselves or through money managers, and these stocks turned out to be the subject of some exciting “theme” but which are inherently sick and prey to economic vicissitudes. They may seem to grow faster initially but the sustainable harvest of their returns is far too uncertain to be the focus of a wise program in investment. Worse still, the companies turned out to be involved in accounting frauds. Their financial numbers were “propped up” artificially to lure in funds from investors and the studiously-assessed asset value has already been “tunnelled out” or expropriated. And western-based fraud detection tools and techniques have not been adapted to the Asian context to avoid these traps.

After a decade-plus journey in the Asian capital jungles, it has been somewhat disheartening as I observe many fraud perpetrators go away scot-free and live a life of super luxury on minority investors’ hard-earned money. And these perpetrators make tempting offers to various parties in the financial community to go along with their schemes. When investors have knowledge in their hands, we have a choice to stay away from these people and away from temptations and do the things that we think are right. With knowledge, we have a choice to invest in the hardworking Asian entrepreneurs and capital allocators who are serious in building a wide-moat business.

The Moat Report Asia
A Service of BeyondProxy LLC
1608 S. Ashland Avenue #27878
Chicago, Illinois 60608-2013

Other offices: London, Singapore, Zurich

“Bamboo Innovators bend, not break, even in the most terrifying storm that would snap the mighty resisting oak tree. It survives, therefore it conquers.”

• The weekly insight is a teaser into the opportunities – and pitfalls! – in the Asian capital jungles.
• Get The Moat Report Asia– a monthly in-depth presentation report of around 30-40 pages covering the business model of the company, why it has a wide moat and why the moat may continue to widen, a special section on “Inside the Leader’s Mind” to understand their thinking process in building up the business, the context – why now (certain corporate or industry events or groundbreaking news), valuations (why it can compound 2-3x in the next 5 years), potential risks and how it is part of the systematic process in the Bamboo Innovator Index of 200+ companies out of 15,000+ in the Asia ex-Japan universe.
• Our paid Members from North America, Europe, the Oceania and Asia include professional value investors with over $20 billion in asset under management in equities, some of the world’s biggest secretive global hedge fund giants, and savvy private individual investors who are lifelong learners in the art of value investing.

Can You Guess This Asian Wide-Moat Company? Comeback Kid and Reinventing the Family Business

Our latest monthly Moat Report Asia for October investigates an Asian-listed company who is the#1 healthy niche snack king in its domestic market with a market share of >73%. The company has spent over 30 years to build up an extensive wide-moat nationwide distribution network penetrating 200,000 Point-of-Sales (POS), including both modern trade (MT) (supermarkets,hypermarkets, convenience stores, gas stations, wholesales stores) and traditional trade (TT) (sundry stores, traditional shops). The company cultivates long-term customer relationships with its strong direct sales team of 200 professionals regularly visiting the stores with over 400 vehicles, comprising of trucks and the innovative mobile cash vans.

We observed that super compounders Ecolab (ECL, MV $34.8bn) and Keyence (6861 JP, MV $26.7bn) have a strong solutions-sales specialist team and we think this Asian company has accumulated deep know-how infused in its direct salesforce team over the years to sustain resilient growth. The company distributes 5 product categories: (1) Snacks eg the Japanese snack brand Calbee; (2) Confectionery, (3) F&B, (4) Medicine, pastille, nutrition food, (5) Personal care and household products. 75% of its sales are domestic while the rest are exported, mainly to Japan (20% of sales).

The company empowers its salesforce, particularly those traveling on mobile sales vans, with the utilization of modern technology in receiving orders, data verification, issuance of sales documents, delivery of goods. The company has created a sophisticated product storage and inventory management system and a delivery system that is flexible, convenient and fast. In terms of inventory management and working capital efficiency, the company performs far better with inventory period at 23 days (comparable peer 73 days) and cash conversion cycle (CCC) of 33 days (comparable peer 89 days). These long-term competitive advantages have translated to a superior ROE of 27.7% and sustainable cashflow generation.

Even when compared to Asian MNC giants Universal Robina Corp (URC PM, MV $9bn) and Calbee(2229 JP, MV $4.3bn) who have scale advantages in cost efficiency and pricing power, the company has surprisingly better fundamental performance in ROE and profitability and is trading at a huge relative valuation discount at its current EV/EBIT 10.7x and EV/EBITDA 10.4x. Net cash at 9% of market value is a healthy reserve that can be productively allocated to capitalize on future growth opportunities without straining the balance sheet. Its attractive 5.6% dividend yield, the highest in the industry, also limits short-term downside risks.

Its unique low-fat high-protein healthy snack and wide-moat distribution network makes the company either an attractive takeover target or long-term strategic partner to the giant snack producers from URC to Mondelez and General Mills, thus providing long-term downside protection in its terminal value.

Organic food and healthy snack company Annie’s was acquired In Sep 2014 by General Mills for $820M at Price/Sales 4x (vs the company’s P/Sales 1.5x), following similar moves by General Mills, Kellogg, Campbell Soup, Hillshire Brands, Tyson Foods, JM Smucker, TreeHouse Goods, WhiteWave etc. The trend of forgoing meals in favor of healthy snacks is accelerating.

It is the flagship vehicle of a family business group whose storied history has been long forgotten following unusual succession challenges in the third generation. Led by the capable son-in-law to the daughter of the third-generation scion, the Group is the ‘comeback kid’ who has successfully resurrected from the 1997/98 Asian Financial Crisis and has listed 4 of its 6 major business assets to derisk the business group governance risk and instill a strong sense of accountability and transparency for long-term going-concern viability. As the flagship vehicle, this Asian listed company will be the most important vehicle in the Group to equitize the governance goodwill and long-term strategic partnerships seeking to leverage its wide-moat distribution network and global export potential. We are impressed by the company’s efforts over the years to develop its human capital in caring about their knowledge by providing them training opportunities and multiple opportunities to engage in company activities to foster sharing and commitment. This is rare in Asian firms and the company deserves credit and a long-term valuation premium.

Warm regards,

KB

Managing Editor

The Moat Report Asia

www.moatreport.com

SMU: http://accountancy.smu.edu.sg/faculty/profile/108141/Kee%20Koon%20Boon

“In business, I look for economic castles protected by unbreachable ‘moats’.”

– Warren Buffett

The Moat Report Asia is a research service focused exclusively on competitively advantaged, attractively priced public companies in Asia. Together with our European partners BeyondProxy andThe Manual of Ideas, the idea-oriented acclaimed monthly research publication for institutional and private investors, we scour Asia to produce The Moat Report Asia, a monthly in-depth presentation report highlighting an undervalued wide-moat business in Asia with an innovative and resilient business model to compound value in uncertain times. Our Members from North America, the Nordic, Europe, the Oceania and Asia include professional value investors with over $20 billion in asset under management in equities, secretive global hedge fund giants, and savvy private individual investors who are lifelong learners in the art of value investing.

Learn more about membership benefits here: http://www.moatreport.com/subscription/

• Individual subscription at $1,994 per year:

https://www.moatreport.com/individual-subscription/?s2-ssl=yes

• Institutional subscription at $5,964 per year: https://www.moatreport.com/institutional-subscription/?s2-ssl=yes

The Moat Report Asia Members’ Forum has been getting penetrating quality dialogues from our subscribers. Questions range from:

• The nuances of internal dealings in Asia, including the case discussion of the recent deal in which HK billionaire’s Lee Shau-kee Henderson Landacquiring Towngas or Hong Kong & China Gas (3 HK) from his family holdings, seemingly déjà vu from the early Oct 2007 transaction when the market peak.
• The case of F&N Singaporespinning out its property unit FCL Trust and getting “free” special dividend-in-specie and the potential risk in asset swap restructuring to deleverage the hidden debt in the entire Group balance sheet.
• The dilemma of whether to invest in a Southeast Asian-listed company and hidden champion with a domestic market share of 60% due to family squabbles and a legal suit over the company’s ownership.
• Discussion of the wise and thoughtful 107-year-old Irving Kahn’s investment into a US-listed but Hong Kong-based electronics company with development property project in Shenzhen’s Qianhai zone and the possible corporate governance risks that could be underestimated or overlooked, as well as their history of listing some assets in HK in 2004.. This is also a case study of “buy one get one free” in John’s highly-acclaimed book The Manual of Ideasin which the “free” property is lumped together with the (eroding) core business to make the combined entity look cheap and undervalued. What are the potential areas that value investors need to watch out for when adapting the SOTP (sum-of-the-parts) valuation method in Asia?
• And many more intriguing questions.

Do find out more in how you can benefit from authentic and candid on-the-ground insights that sell-side analysts and brokers, with their inherent conflict-of-interests, inevitable focus on conventional stock coverage and different clientele priorities, are unwilling or unable to share. Think of this as pressing the Bloomberg “Help Help” button to navigate the Asian capital jungle. Institutional subscribers also get access to the Bamboo Innovator Index of 200+ companies and Watchlist of 500+ companies in Asia and the Database has eliminated companies with a higher probability of accounting frauds and  misgovernance as well as the alluring value traps.

Our 8^th run of the series of workshop From the Fund Management Jungles: Value Investing Exposed and Explored – (Part 1) Moat Analysis, (Part 2) Tipping Point Analysis and (Part 3) Detecting Accounting Fraud – on 14 June 2014 has been well-received with serious value investors, professionals, and serious lifelong learners attending, with some who flew in from Jakarta and KL!..

Our 9th workshop will be sometime later in the year.

Thank you for your support all this while!

Thank you so much for reading as always.

Warm regards,

KB Kee

Managing Editor

The Moat Report Asia

Singapore

Mobile: +65 9695 1860

A Service of BeyondProxy LLC

1608 S. Ashland Avenue #27878

Chicago, Illinois 60608-2013

Other offices: London, Singapore, Zurich

P.S.1 Here is a little more about my background:

KB Kee has been rooted in the principles of value investing for over a decade as an analyst in Asian capital markets. He was head of research and fund manager at a Singapore-based value investment firm. As a member of the investment committee, he helped the firm’s Asia-focused equity funds significantly outperform the benchmark index. He was previously the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company.

He holds a Masters in Finance and degrees in Accountancy and Business Management, summa cum laude, from Singapore Management University (SMU) and had also published articles on governance and investing in the media, as well as published an empirical research paper Why ‘Democracy’ and ‘Drifter’ Firms Can Have Abnormal Returns: The Joint Importance of Corporate Governance and Abnormal Accruals in Separating Winners from Losers in the Special Issue of Istanbul Stock Exchange 25^th Year Anniversary Best Paper Competition, Boğaziçi Journal, Review of Social, Economic and Administrative Studies, Vol. 25(1): 3-55. KB has also presented his thought leadership as a keynote speaker in global investing conferences. KB has trained CEOs, entrepreneurs, CFOs, management executives in business strategy, value investing, macroeconomic, industry trends, and detecting accounting frauds in Singapore, HK and China, and had taught accounting at the SMU where he is currently an adjunct lecturer.

P.S.2  Why do I care so much about doing The Moat Report Asia for you?

My personal motivation in embarking on this lifelong journey has been driven by disappointment from observing up close and personal the hard-earned assets of many investors, including friends and their families, burnt badly by the popular mantra: “Ride the Asian Growth Story!” I witnessed firsthand the emotional upheavals that they go through when they invest their hard-earned money – and their family’s – in these “Ride The Asian Growth Story” stocks either by themselves or through money managers, and these stocks turned out to be the subject of some exciting “theme” but which are inherently sick and prey to economic vicissitudes. They may seem to grow faster initially but the sustainable harvest of their returns is far too uncertain to be the focus of a wise program in investment. Worse still, the companies turned out to be involved in accounting frauds. Their financial numbers were “propped up” artificially to lure in funds from investors and the studiously-assessed asset value has already been “tunnelled out” or expropriated. And western-based fraud detection tools and techniques have not been adapted to the Asian context to avoid these traps.

After a decade-plus journey in the Asian capital jungles, it has been somewhat disheartening as I observe many fraud perpetrators go away scot-free and live a life of super luxury on minority investors’ hard-earned money. And these perpetrators make tempting offers to various parties in the financial community to go along with their schemes. When investors have knowledge in their hands, we have a choice to stay away from these people and away from temptations and do the things that we think are right. With knowledge, we have a choice to invest in the hardworking Asian entrepreneurs and capital allocators who are serious in building a wide-moat business.

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• The weekly insight is a teaser into the opportunities – and pitfalls! – in the Asian capital jungles.
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Can the Market Add and Subtract? The Puzzling Yahoo Negative Stub from Alibaba’s Soaring Value and Are There Other Stubs in Asia?

Do you believe in “reincarnation” in asset pricing? We seem to have entered into such a vortex with the explosive listing of Alibaba, China’s dominant ecommerce company, on 19 Sep, 2014. Yahoo (YHOO, MV $40.7bn) is now valued at less than its $45bn stake in its Asian assets, which include 16% in Alibaba (BABA, MV $231.4bn) and 35% in Yahoo Japan (4689 JP, MV $23.1bn), or an implied valuation of negative $5bn (excluding $6.6bn in cash from selling bits of Alibaba over the years) for the core online-ad business.

The earlier version happened on March 2, 2000 when 3Com carved out 5% of Palm for a public listing to unleash its true value and declared that it would eventually spin off its remaining 95% stake to 3Com shareholders at a ratio of 1.5 Palm shares for every 3Com share before the end of the year. The 3Com shares thus represented 95% ownership of Palm and its non-Palm core business which were less fashionable but more profitable than Palm. At its height, 3Com also owned the naming rights to the San Francisco stadium where the city’s 49ers football team plays. In other words, 3Com should trade for more than 1.5 times the price of Palm stock. The day before the Palm IPO, 3Com closed at $104 per share. After the first day of trading, Palm closed at $95 and soared 4-folds in value to $53.4bn, implying that 3Com should have jumped to at least $145. Instead, 3Com fell to $81.8 and languished at $28bn. Investors were willing to buy expensive shares of Palm rather than to buy the cheap Palm shares embedded in 3Com and get 3Com thrown in. The “stub value” of 3Com was negative $63 per share: the non-Palm core business of its parent had an implied valuation of negative $25bn. Yet, this mispricing does not create exploitable arbitrage opportunities. Over the next two years, Palm shares plunged by more than 90%. 3Com was later acquired in 2009 by HP (HPQ, MV $68.6bn) for $2.7bn.

An even earlier version happened in 1923 when the young fund manager Benjamin Graham noticed that althoughDu Pont (DD, MV $65.2bn) owned a substantial number of GM (GM, MV $54.5bn) shares, DuPont’s market capitalization was about the same as the value of its stake in GM. Pierre du Pont, under his presidency, had used surplus cash to buy a large block of GM shares. Du Pont had a stub value of zero despite the fact that Du Pont was one of America’s leading industrial firms. Graham bought Du Pont and shorted seven times as many shares of GM and profited when Du Pont subsequently rose.

3Com, Du Pont and Yahoo are “equity stubs” in which publicly-traded subsidiaries or investments make up a surprisingly large fraction of the value of their parent company, so that the equity stub – the claim to the parent company’s businesses outside of the subsidiary – has low or even negative value.

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An important question for value investors is whether there are other stubs in Asia that are not seductive value traps? We wish to distinguish stubs from sum-of-the-parts (SOTP) situations which are mainly a hodgepodge of multiple diversified bets and mainly comprise of some property assets. Stubs are akin to the investments Naspers (NPN SJ, MV $50.4bn) made by capital allocator Koos Bekker in Tencent (700 HK, MV $151bn). Naspers paid $30m to buyout 50% of Tencent in 2005 before its 2007 listing and now its 33.85% stake in Tencent is worth $51B, more than its $50.4bn market value.

From our observation, most Asian entrepreneurs are…

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An Asian-Listed ‘Stub’ Helmed by Third-Generation Leader Mr. S – Stock Price Performance, 1982-2014

Charles Kettering (1876-1958), the American inventor-entrepreneur, had said, “You will never stub your toe standing still. The faster you go, the more chance there is of stubbing your toe, but the more chance you have of getting somewhere.” To avoid being stubbed in the toe by sum-of-the-parts (SOTP) value traps that are prevalent in the Asian capital jungles such as Taihan, it is critical to keep in mind the underlying wide-moat business model that is the foundation to generate sustainable cashflow in quality stubs such as … in order to journey far in Asia.

Warm regards,

KB

Managing Editor

The Moat Report Asia

www.moatreport.com

SMU: http://accountancy.smu.edu.sg/faculty/profile/108141/Kee%20Koon%20Boon

To read the exclusive article in full to find out more about the story of the other “stubs” in Asia, please visit:

• Can the Market Add and Subtract? The Puzzling Yahoo Negative Stub from Alibaba’s Soaring Value and Are There Other Stubs in Asia? Sep 22, 2014 (Moat Report Asia, BeyondProxy)

“In business, I look for economic castles protected by unbreachable ‘moats’.”

– Warren Buffett

The Moat Report Asia is a research service focused exclusively on competitively advantaged, attractively priced public companies in Asia. Together with our European partners BeyondProxy and The Manual of Ideas, the idea-oriented acclaimed monthly research publication for institutional and private investors, we scour Asia to produce The Moat Report Asia, a monthly in-depth presentation report highlighting an undervalued wide-moat business in Asia with an innovative and resilient business model to compound value in uncertain times. Our Members from North America, the Nordic, Europe, the Oceania and Asia include professional value investors with over $20 billion in asset under management in equities, secretive global hedge fund giants, and savvy private individual investors who are lifelong learners in the art of value investing.

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Our latest monthly issue for the month of September investigates a Malaysian-listed company who is the #1 private pharmaceutical wholesaler and also one of the largest private sector manufacturer of off-patent medicines in its domestic market. Its integrated business model from pharma manufacturing to wholesale, distribution and marketing has carved out top-selling own-branded products such as #1 in medicated powder, #1 cough mixture, #1 cough expectorant etc. With its network of warehouses strategically located throughout the country, the company is able to provide comprehensive coverage and rapid access to markets and customers, delivering the “Medicines on Call” value proposition to over 4,000 private-sector customers from private hospitals, pharmacies to supermarkets and also serves as the long-term channel partner to international brands such as GSK, J&J, 3M, Colgate Palmolive, Nestle for over 30 years etc. From FY2014 onwards, the company has operationalized the business to contract manufacture orthopedic components for top MNCs with the full array of machining, casting, coating and forging capabilities. In an economy where fortunes are built from government concessions or licenses, the company has forged a different path by relying on its own capabilities to provide quality pharmaceutical products and healthcare services largely in the private sector. In an economy where fortunes are built from government concessions or licenses, the company has forged a different path by relying on its own capabilities to provide quality pharmaceutical products and healthcare. Dr K, the chairman and CEO, and his management team have exercised prudence and discipline in executing their operations and capex plans with a strong balance sheet fortified by net cash that’s around 10.5% of market value while deepening their core competencies in warehousing, logistics, sales and marketing to connect to the fragmented market of over 4,000 clients. For the business model of a pharmaceutical wholesaler-distributor, working capital management is critical. In terms of inventory management efficiency, at the inventory turnover period of 42 days, the company is nearly twice as efficient as state-linked giants and is nearly on par with world leaders McKesson and AmerisourceBergen, an impressive feat given the logistics challenge in emerging markets. The company’s 9.6% ROA is nearly double that of state-linked leader. AtEV/EBIT 10.1x, EV/EBBITDA 8.4x, PE14e 10.2x and P/Book 1.9x, the company is reasonably decent in valuations for its resilient earnings and cashflow growth. Giant drug dealers McKesson (MCK US, MV $44.4bn) and AmerisourceBergen (ABC, MV $17.4bn) are also on the global hunt for acquisition targets; McKesson has bought Germany’s Celesio, one of Europe’s largest drug distributors, for $5.4bn in 4Q13, to link up the supply chains of Europe and US; ABC has acquired a 19.9% stake in Brazilian drug wholesaler Profarma in March 2014 for $100m. More consolidation in the sector globally is likely and could be the catalyst to drive up the valuation of quality emerging market companies in the sector. Long-term downside protection in terminal value is provided by MNCs who will be interested to acquire or partner with the company to possess its valuable wide-moat advantage in its network of warehouses and wholesale-distribution know-how to reach the fragmented customers. The company has achieved an impressively consistent and improving performance in difficult times and is well-positioned in the local pharmaceutical industry which is among the few industries quite unaffected by economic cycles as the demand for drugs will continue even in difficult times. Public healthcare services in Asia face the problem of social and financial sustainability and the overcrowded public hospitals and clinics have sparked growing demand for reasonably-priced and quality private healthcare services, generic drugs and consumer healthcare products of which the company is a key provider and beneficiary.

Our past monthly issues examine:

• An Asian-listed company who’s the leading ecommerce group in its home country with the complete platform coveragein the Amazon-type of B2C ecommerce of selling directly to end consumers (Sales/Net Profit: 90%/78%), Rakuten-type of B2B2C platform (Sales/Net Profit: 4%/12%) to support the online SME merchants who in turn sell to the end consumers, and the eBay-type of C2C auction site (Sales/Net Profit: 2%/21%) where individuals buy and sell to one another. This “Amazon-Alibaba” is highly profitable with recurring free cashflow (FCF yield 4.6-5% compounding at 25% in the next 3-5 years) by pioneering the world’s-first 24-hour delivery promise and guarantee when world-class logistics experts said it cannot be done. In emerging markets and Asia where logistics costs is 15-20% of GDP, most ecommerce companies fail to scale up due to lack of fulfillment capabilities and inventory risk became the killing blow as they pursue growth without the intangible know-how. The company designs and builds its own warehouses to provide fast and efficient delivery with 99.68% on-time rate and also complete backend services to suppliers, widening the gap between itself and peers. With its superior infrastructure, the company is able to provide consumers a one-stop shopping experience with all goods purchased from different vendors packaged into a single box and delivered to the client’s door. The company has consignment agreements with suppliers which allow it to have control over inventory management but carry no liability of inventory on its balance sheet, in other words, there is minimal inventory risk for the company to scale up sustainably and without the usual accounting risks that plagued the ecommerce companies. With (1) a superior ROE of 23.6% due to its wide-moat business model in 24-hour delivery system, (2) negative cash conversion cycle (-29 days) in its unique warehouse system with minimal inventory risk, (3) a sustained 25-30% recurring earnings and cashflow growth per annum in the next 5 years, especially a long run-way in disrupting traditional retailers, and (4) potential exponential growth in its option value in the third-party electronic payment business, the company can scale up multiple times. Short-term downside risk is protected by its healthy $128m net-cash balance sheet (15% of MV) and proven management execution in prudent capex expansion to support sustainable quality earnings growth. Its terminal value and long-term downside risk will be protected by giants Alibaba, Rakuten, eBay, Amazon who wish to swallow it up to possess its valuable trust and brand equity support it enjoys and its wide-moat business model in 24-hour delivery system. The company is one of the few Asian ecommerce companies with good governance and low accounting risks with its net-value revenue recognition method and it deserves a valuation premium. Upcoming deregulation in third-party electronic payment with the passing of the law in Sep 2014 will result in various government restrictions to be removed, paving the way for the company to introduce stored-value payments, O2O payment, P2P payment (money transfer without transactions), multiple currencies’ payments, big data analysis, payment services for customers outside the group to boost transaction volume and scale up its existing proprietary PayPal/AliPay business. Led by the inspiring and highly-determined founder and Chairman who established and listed the company in 1998 and 2003 respectively, the company has overcome the multiple obstacles to ecommerce transactions in its home market. The founder described the obstacles to ecommerce transactions as ‘friction’, and that he “resolve to take on the Life’s Task to reduce this ‘friction’”.

• An Asian-listed company who’s the global #1 and #2 maker of two types of patient monitoring devices for both clinical- and home-use. Founded in 1981 and listed in 2001, the company’s reliable manufacturing technology platform for over 30 years has enabled it to build a global durable franchise in the niche patient monitoring device market that has stable resilient growth and yet is experiencing potential disruptions led by its new innovation. A secret to its success is its in-house capabilities to combine Swiss design, high-precision electronics and sensors components with clinical healthcare to produce world-class products with cost competitiveness. The firm has competitive technology and patents especially its core competence of having an algorithm to allow fast reading/filtering of signals and outputting the accurate results in a short period of time. Thecompany has the potential to consolidate the market further. The company is also a sticky ODM partner to reputable companies including Wal-Mart, Costco, CVS and it has a diversified customer base with none of the customers accounting for more than 10% of its sales. The company demonstrated that it has bargaining power over its powerful customers with the ability to build its own brand since 1998 (62% of overall sales). 91% of its sales are to developed markets in US and Europe. The company is trading at EV/EBIT 9.7x and EV/EBITDA 8.8x and has an attractive dividend yield at 5.6% and a strong balance sheet with net cash as percentage of market value and book equity at 23% and 47% respectively. The firm has also undertaken the unusual capital management program to reduce 10% of its shares outstanding in Sep 2012 to boost capital efficiency by utilizing the comfortable net cash position. The proactive shareholder-friendly stance backed by its strong net cash position should limit any downside in share price. The company’s terminal value and downside risk will be protected by giants such as J&J, Bayer, Abbott etc who wish to swallow it up to possess its valuable manufacturing technology platform and worldwide patents in algorithm-technology. The company’s worldwide patents in algorithm-technology has been commercialized into an innovative product series that is at the heart of its total solution service business model. This valuable intangible asset is not factored into long-term valuation.The innovative product with the algorithm measurement technology are not merely additional features; it “forces” the clinical community to adopt them as the standard, which in turn helps drive home-use penetration as patients seek a consistent and integrated healthcare experience. It transforms the product into a unique strategy that incorporates software development to create value-added services for health monitoring and collaborating with hospitals and governments on tele-healthcare projects. As a result of its wide-moat, the company has a far superior ROE at 20.9% that is nearly double that of its key giant conglomerate rival. When we compare EV/EBIT relative to ROE and ROA, the company is cheaper by as much as 120-150% when compared to its key giant conglomerate rival. The stock price of the company is down nearly 20% from its recent high in end March 2014 on profit-taking by short-term investors. Share price is back to May 2013 level, representing an attractive opportunity to take position in this long-term durable franchise. The stable long-term shareholdings and patient capital by the founder and the management team who together own around 48% of the equity has enabled the firm to adopt a very long-term approach to building its business and cultivating new growth areas. While he may sometimes be slightly over-optimistic and thinking too far ahead with his long-term opinions, this  idealistic engineer-visionary-philosopher has done a fantastic job in continuously defying the odds of many skeptics by growing the company from a small startup into one of the world’s leading patient monitoring equipment company. He is the rare Asian entrepreneur who was persistent in building his own brand despite the threat of offending his ODM customers. He was also early in cultivating and coordinating a global network with high-tech component, R&D and manufacturing in his home country, manufacturing, assembly and packaging in Shenzhen, China and medical R&D and clinical testing center in Europe, including making the difficult decision to establish a direct marketing sales force in Europe and North America given the high cost. Unlike most Asian business owners whose interest and focus in the core business starts to wane due to complacency from growing personal wealth and the inability to scale the core business, the founder is genuinely passionate in the company’s ability to add value to the patients and society. The firm can effectively run without the founder with the long-term corporate culture and management system in place, yet he can inject great value as the steward in new innovations; we believe that this combination is rare for an Asian company and deserves a valuation premium.

• The world’s #1 ODM (Original Design Manufacturer) and global #5 manufacturer of a consumer healthcare device product that is used frequently, even daily, thus providing the foundation for stable recurring cashflow. This company is also a hidden champion in a niche product segment (50-55% of group’s sales) that has become a high-growth fashion product currently accounting for less than 10% of the overall industry. The company is able to mass-manufacture this niche product, but not the giants, because of its unique process IP in flexible manufacturing system and know-how to handle large-scale complex orders. The manufacture of this product itself is difficult to replicate and requires FDA/CE licenses because of its medical device nature and the entry barrier is not capital but the know-how and R&D expertise. In particular, the manufacturing integrates different fields of science including polymer chemistry, physics, optics, engineering, materials control, process control, microbiology, and, injection molding. The firm has also developed a proprietary system of tracking the manufacturing process of different sets of product so that if a quality issue arose, when and where the problem set of products was being produced could be swiftly identified, thus diminishing the scale and cost of product recall. This system has helped the firm win the long-term trust of its ODM customers to place stable large orders. The Big Four giants do not have such a system and have to incur substantial losses from product recalls. The company also possess its own brand which has many loyal followers and support in its home market where it enjoys a 30% market share and contributes to 25% of group’s saleswhile sticky ODM customers account for 75% of group’s sales, mainly from the Japan market. As a result of its wide-moat advantages, the firm enjoys a consistently high ROE of 41%, double or triple that of the giants. From FY07 onwards, even during the depths of the Global Financial Crisis in 2007/09, the firm has not raised equity. Since listing in Mar 2004, the company has only done one rights issue in May 2005. Also, it is able to sustain a strong stable cash dividend payout (>70% with 3% yield) with its healthy net-cash balance sheet (net cash $30m; net cash-to-equity ratio 23%) and proven management execution in prudent capex expansion to support sustainable quality earnings growth. M&A deals in the healthcare and medical device sector has been growing due to their strong defensive nature and giants seeking growth to overcome their own patent cliff. The firm will always be an attractive takeover target by giants who wish to swallow it up to possess its valuable flexible manufacturing system and know-how to fill their own missing competency gap and hence will enjoy long-term downside protection in its terminal value. In the battle between “ODM vs Brand”, we find the story of the company to be quite similar to that of TSMC (2330 TT, MV $103bn), now the largest ODM foundry in the world. “Skate to where the puck is going to be, not where it has been,” as hockey legend Wayne Gretzky advised. In our view, the profit and valuation premium in the value chain will start to skate to the “Inno-facturers” who are the hidden ODM innovators (the brand behind brands) consolidating the industry, such as TSMC and this company. While its valuation is not cheap with EV/EBIT (FY13) at 20.6x, when we compare EV/EBIT relative to ROE, the company is relatively cheap, by as much as 130-220% when compared to giants and other comparables. When we compare EV/EBITDA relative to ROE, the valuation gap is 90-160%. This long-term valuation gap implies that the company, with its far superior and sustainable ROE, could potentially double to $2.4bn, as it continues to consolidate its niche product segment and enter into a new product cycle of an innovative product whose patents are expiring in 2014/15 (US/worldwide) to make ASP/margin improvements in sustaining quality profits and cashflow. Its share price has dropped 18% from its recent high and underperformed the index by 26% in the last six months. This will present a buying opportunity for long-term value investors who can penetrate beyond conventional valuation metrics because of a deep understanding of its business model and underlying source of its wide-moat advantages. In Asia, many firms break apart or become value traps due to shareholder conflict, envy and differences in opinion on the business direction of the company. The stable long-term corporate culture infused by the late founder, who established the company in 1986 with the current executive chairman and 2 other key shareholders, to combine the energy and ideas of everyone to work hard to keep the business running forever is underappreciated.

• The Home Depot of Asiawhich has the largest market share in its home country and now seeks to expand regionally. It is one of the few home improvement retailers in the world which is able to achieve a structural negative cash conversion cycle (CCC) at -39 days for resilient, recurring and sustainable operating cashflow to enable the expansion of its store network while keeping a healthy balance sheet. It is hard to achieve negative cash conversion cycle (CCC) as a home retailer as compared to a supermarket retailer as the product nature is more durable. Even Home Depot, Lowe’s and Bed Bath & Beyond (BBBY) are not able to achieve a negative CCC. Led by the capable owner-operators since 1995, the company is a pioneer in proactively creating awareness and demand in the minds of consumers that upgrading your home can be fun and in incremental affordable steps. Its creative branding has resulted in the firm to become the “first on customers’ mind”, or what Charlie Munger elucidated as the “psychological wide-moat” advantage. 80% of sales are generated customers looking for home improvement and renovation ideas and solutions.  Growth is supported by the management’s proven ability to identify and cater to dynamic changes in customer preferences. The firm’s comprehensive pre and aftersales service creates brand loyalty and sustains long-term sales. The merchandizing management is tailored to the peculiarities of customer preferences in each area to drive same store sales growth with creative customization by store, location, season and events. Its key strategy to expand its profit margin is to increase its higher-margin house brands and product-mix management. Its EBITDA/sqm of $400/sqm was higher than Home Depot until Home Depot experienced a rebound last year to $500/sqm. The firm’s resilient sales are supported by its unrivalled network of diverse locations throughout the country. Its bold vision and successful “Blue Ocean” execution in the highly fragmented second-tier markets has created a powerful wide-moat advantage that will last for many years to come. In short, the management have proven their ability to execute in difficult market and industry conditions especially in the past 5 to 7 years during the 2007/09 global financial crisis with the firm emerging much stronger. The Illinois Institute of Technology engineering graduate and quiet billionaire owner behind the home retailer is one of the few Asian business tycoons who has the thirst to scale up the business in a sustainable way, as opposed to opportunistic ventures, having been largely influenced by his early years experience observing the success of American wide-moat firms. If we can adjust the EV/EBITDA valuation metric to reflect the CCC, the company’s EV/EBITDA of 18.5x will be lower at 10-11x, while Home Depot’s EV/EBITDA 11x will be higher at 13x. Noteworthy is that Home Depot has a negative free cashflow throughout FY1989-2001 (13 consecutive years!) and yet market cap has climbed from $1.5bn to $103bn. Home Depot compounded despite the ugly valuations during the capex ramp-up. This once again highlights that the power of wide-moat is often underappreciated, misunderstood and overlooked. When Home Depot generated $180m in operating cashflow in FY1992, quite similar to this Asian firm now, Home Depot is valued at $5bn (vs $3bn). Store network is expected to double in the next 4-5 years, representing a potential doubling in market value.

• The Northeast Asian-listed companywho is the world’s largest maker of an essential component with applications in apparel, shoes, diapers, car seats etc. All top 20 global athletic shoe brands, including Nike, Adidas, Reebok, Sketchers, UnderArmor are customers and this Asian innovator with R&D capabilities has forged long-term “spec-in” partnerships with them. Its broad product offering is protected by over 110 patents. By locating its Pan-Asian production plant network in China, Taiwan, Vietnam and Indonesia close to its major clients, including sales/customer service centers and warehouses in US and Europe, the firm is better positioned to understand their requirements, deliver fast and meet their needs. While top 10 athletic shoe brands account 40% of its revenue, the firm has a diversified clientele base of over 10,000 customers, giving it resilience and growth with both the established and emerging brands as clients. The company is trading at PE14e 12x, EV/EBITDA 7.1x and EV/EBIT 10.6x with a dividend yield of 3.9%. Interestingly, its EBITDA margin is double that of Adidas and its 8.7% net margin is higher than Adidas’ 5.4%, though below Nike’s 9.8%. Given the tipping point of its Pan-Asian production network and contributions from its new products and as capex tapers off in the next few years, free cashflow could be around $50-60m and applying a P/FCF of 15x would yield a market value of $750-900m,, representing apotential upside of 100-150%. Thus, the firm offers a similar quality growth trajectory to Nike/Adidas with its unique knowledge-based business model and yet trades at a more attractive valuation and higher dividend yield as downside protection.

• The Middleby of Asia commanding a dominant market share of over 80% in hypermarkets, 50% in chain outlets, 30% in 4- to 5-star hotels in China and an overall 30% in its home market. Yet, no single customer accounts for more than 5% of its revenue. Just to recall for value investors, NYSE-listed Middleby, with its sleepy and boring business, has compounded 100-fold from around $50m to $5.7bn since its tipping point in 1999. The founders of this Asian family business demonstrated clear dedication in building up the company with its wide-moat business model backed by a strong and unique distribution/marketing network in finding, winning and binding new customers to build massive brand equity and long-lasting relationships with clients over time. Their devotion to its core product for nearly 20 years results in maximum problem-solving skills, innovative strength and product leadership and hence, to ever greater customer benefit that will protect the company to consolidate the fragmented market and provide ample opportunities to continue its profitable growth. The company is currently trading at PE13e 15.8x and an undemanding EV/EBIT 10.1x and EV/EBITDA 9.5xand its growth potential based on its unique business model is not priced in. There is a structural re-rerating of niche business models with (1) diversified client base, (2) steady revenue streams, (3) lean capex requirements that creates ample free cashflow and defensive growth. Based on PE, P/CFO and EV/EBIT, the company is trading at a 40-50% discount to the foreign listed comparables despite more efficient use of assets in generating profits and cashflow. It has an attractive 7% earnings yield growing at 20% over the next 3-5 years and a 3.8% dividend yield that is supported by its strong cashflow generation ability, steady revenue stream and lean capex requirements to limit downside risks in valuation. Based on the growth plans to penetrate new product and customer segments; build its third plant in India in addition to the ones in its home market and in China; and potential bolt-on acquisition opportunities with its healthy balance sheet in net-cash position, it has the potential to double its operating cashflow in the next 3-5 years and market value could double, representing an upside potential of 100-140%.

The Moat Report Asia Members’ Forum has been getting penetrating quality dialogues from our subscribers.Questions range from:

• The nuances of internal dealings in Asia, including the case discussion of the recent deal in which HK billionaire’s Lee Shau-kee Henderson Landacquiring Towngas or Hong Kong & China Gas (3 HK) from his family holdings, seemingly déjà vu from the early Oct 2007 transaction when the market peak.
• The case of F&N Singaporespinning out its property unit FCL Trust and getting “free” special dividend-in-specie and the potential risk in asset swap restructuring to deleverage the hidden debt in the entire Group balance sheet.
• The dilemma of whether to invest in a Southeast Asian-listed company and hidden champion with a domestic market share of 60% due to family squabbles and a legal suit over the company’s ownership.
• Discussion of the wise and thoughtful 107-year-old Irving Kahn’s investment into a US-listed but Hong Kong-based electronics company with development property project in Shenzhen’s Qianhai zone and the possible corporate governance risks that could be underestimated or overlooked, as well as their history of listing some assets in HK in 2004.. This is also a case study of “buy one get one free” in John’s highly-acclaimed book The Manual of Ideasin which the “free” property is lumped together with the (eroding) core business to make the combined entity look cheap and undervalued. What are the potential areas that value investors need to watch out for when adapting the SOTP (sum-of-the-parts) valuation method in Asia?
• And many more intriguing questions.

Do find out more in how you can benefit from authentic and candid on-the-ground insights that sell-side analysts and brokers, with their inherent conflict-of-interests, inevitable focus on conventional stock coverage and different clientele priorities, are unwilling or unable to share. Think of this as pressing the Bloomberg “Help Help” button to navigate the Asian capital jungle. Institutional subscribers also get access to the Bamboo Innovator Index of 200+ companies and Watchlist of 500+ companies in Asia and the Database has eliminated companies with a higher probability of accounting frauds and  misgovernance as well as the alluring value traps.

Our 8^th run of the series of workshop From the Fund Management Jungles: Value Investing Exposed and Explored – (Part 1) Moat Analysis, (Part 2) Tipping Point Analysis and (Part 3) Detecting Accounting Fraud – on 14 June 2014 has been well-received with serious value investors, professionals, and serious lifelong learners attending, with some who flew in from Jakarta and KL!..

Our 9th workshop will be sometime later in the year.

Thank you for your support all this while!

Thank you so much for reading as always.

Warm regards,

KB Kee

Managing Editor

The Moat Report Asia

Singapore

Mobile: +65 9695 1860

A Service of BeyondProxy LLC

1608 S. Ashland Avenue #27878

Chicago, Illinois 60608-2013

Other offices: London, Singapore, Zurich

P.S.1 Here is a little more about my background:

KB Kee has been rooted in the principles of value investing for over a decade as an analyst in Asian capital markets. He was head of research and fund manager at a Singapore-based value investment firm. As a member of theinvestment committee, he helped the firm’s Asia-focused equity funds significantly outperform the benchmark index. He was previously the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company.

He holds a Masters in Finance and degrees in Accountancy and Business Management, summa cum laude, from Singapore Management University (SMU) and had also published articles on governance and investing in the media, as well as published an empirical research paper Why ‘Democracy’ and ‘Drifter’ Firms Can Have Abnormal Returns: The Joint Importance of Corporate Governance and Abnormal Accruals in Separating Winners from Losers in the Special Issue of Istanbul Stock Exchange 25^th Year Anniversary Best Paper Competition, Boğaziçi Journal, Review of Social, Economic and Administrative Studies, Vol. 25(1): 3-55. KB has also presented his thought leadership as a keynote speaker in global investing conferences. KB has trained CEOs, entrepreneurs, CFOs, management executives in business strategy, value investing, macroeconomic, industry trends, and detecting accounting frauds in Singapore, HK and China, and had taught accounting at the SMU where he is currently an adjunct lecturer.

P.S.2  Why do I care so much about doing The Moat Report Asia for you?

My personal motivation in embarking on this lifelong journey has been driven by disappointment from observing up close and personal the hard-earned assets of many investors, including friends and their families, burnt badly by the popular mantra: “Ride the Asian Growth Story!” I witnessed firsthand the emotional upheavals that they go through when they invest their hard-earned money – and their family’s – in these “Ride The Asian Growth Story” stocks either by themselves or through money managers, and these stocks turned out to be the subject of some exciting “theme” but which are inherently sick and prey to economic vicissitudes. They may seem to grow faster initially but the sustainable harvest of their returns is far too uncertain to be the focus of a wise program in investment. Worse still, the companies turned out to be involved in accounting frauds. Their financial numbers were “propped up” artificially to lure in funds from investors and the studiously-assessed asset value has already been “tunnelled out” or expropriated. And western-based fraud detection tools and techniques have not been adapted to the Asian context to avoid these traps.

After a decade-plus journey in the Asian capital jungles, it has been somewhat disheartening as I observe many fraud perpetrators go away scot-free and live a life of super luxury on minority investors’ hard-earned money. And these perpetrators make tempting offers to various parties in the financial community to go along with their schemes. When investors have knowledge in their hands, we have a choice to stay away from these people and away from temptations and do the things that we think are right. With knowledge, we have a choice to invest in the hardworking Asian entrepreneurs and capital allocators who are serious in building a wide-moat business.

The Moat Report Asia
A Service of BeyondProxy LLC
1608 S. Ashland Avenue #27878
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Other offices: London, Singapore, Zurich

“Bamboo Innovators bend, not break, even in the most terrifying storm that would snap the mighty resisting oak tree. It survives, therefore it conquers.”

• The weekly insight is a teaser into the opportunities – and pitfalls! – in the Asian capital jungles.
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A Day in the Cost Accounting 101 Class: The Case of 21Vianet and Cloud Computing Accounting Fraud

The following is an email excerpt sent by KB Kee, Managing Editor of The Moat Report Asia, to his students in his cost accounting 101 class at the Singapore Management University (SMU) to discuss briefly about the recent alleged accounting fraud case of 21Vianet (VNET US, MV $1.3bn).

From: KEE Koon Boon

Sent: Thursday, September 11, 2014 10:56 AM

Subject: ACCT 102 – Fraud Overhead: Cost accounting system of data centers? Alleged massive accounting fraud at 21Vianet (VNET)

Dear All,

21Vianet, dubbed the “Rackspace of China”, has been involved in an alleged accounting fraud yesterday in a 121-page report by a short-seller.

This is another interesting perspective on “cost allocation” of “service department costs”, the topic which we covered yesterday, including the article on “Fraud Overhead” that talks about indirect costs that are hard to allocate to individual “jobs”, manifested in the other article about billionaire Elon Musk’s SolarCity (SCTY US, MV $6.9bn) embroiled in accounting woes from the cost overhead allocation problem.

Companies have been outsourcing their IT service department costs, including data center costs, to reduce capex investments and cost allocation problems – but how about the other side, the data center operator that is taking on such business? What is their cost and financial accounting system like in the revenue and expense recognition as they take on different “jobs” with the “shared” infrastructure at different usage and capacity utilization?

21Vianet could have potentially employed two or three of the four basic related-party transaction (RPT) ideas that are prevalently used by many listed Asian companies to engage in the “propping” and “tunneling” of assets and escape western-based fraud detection techniques such as the abnormal accruals analysis used by both institutional investors and auditors; it’s part of the framework and proposed course elective on Accounting Fraud in Asia that I hope to launch and share in SMU. One of these used by the actual “syndicates” and “manipulators” is the “Deals Potion” to extinguish fake receivables that were used to book artificial sales when the receivables are cancelled and the set-off are booked as Goodwill, Intangible Asset and Other Long-Term Assets that inflate the balance sheet. The accounting transgression thumbprint left behind via these related-party transactions usually correspond to the artificial sales created and can serve as a value-added predictive tool to highlight potential accounting fraud.

In the 121-page report on 21Vianet, you can also find that it talks about cost behavior and Operating Leverage (what we covered in Week 2 Cost Behavior and CVP Cost Volume Profitability Analysis) on Pages 20-21 etc. Hopefully, through 21Vianet, we get to see how cost and financial accounting interact to help us understand the problem of cost allocation (in the case of 21Vianet, the indirect cost overheads are likely improperly “capitalized” and shifted into the balance sheet to inflate income) and capex investment (capital budgeting in Week 11) in building a business.

The accounting for costs associated with cloud computing is also more complex that it seems and those who are interested can go on to read more in this interesting article by Deloitte. SEC’sinvestigation on IBM’s cloud computing accounting in May last year is also a harbinger of the potential accounting fraud problems and a good summary is provided on the accounting impact on business valuation:

“Cloud computing gives rise to two overarching accounting considerations. First, with respect to revenues, how does one appropriately recognize revenue and expenses on service contracts that have “multiple elements,” such as platform development, data migration and hosting, training, and support services?… Important for potential accounting fraud, the effect of premature recognition could be to record revenue before it is earned or realized, artificially inflating revenues in current periods. One area of revenue accounting that is especially tricky and subject to significant judgment is determining the “Best Estimate of Selling Price” or BESP. That occurs when one element of a multiple-element transaction cannot be objectively verified based on internal or external evidence of value and must be estimated using management’s “best judgment.”

Second, with respect to costs, which costs should be capitalized and amortized over the life of the service and which costs should be expensed in the year incurred?… Were costs improperly capitalized, the effect could be to reduce costs and increase income in a given period, although the offsetting capitalization may lower return on assets.”

More articles about SEC’s investigation of IBM’s cloud computing accounting can be found here:

• IBM Defends Cloud-Computing Accounting Amid SEC Probe (Bloomberg)
• IBM and others facing the cloudy business of accounting for the cloud (Fortune)

An old email excerpt (edited) that triggered my memory about the company 21Vianet in Jun 2013, when I was also in HK doing up a one-day workshop for the top management team of an Asian-listed tech company about tech business models and innovation:

From: Bamboo Innovator [mailto:bambooinnovator@gmail.com]

Sent: Thursday, 27 June, 2013 11:34 AM

Subject: RE: Bamboo Innovator Letter – Uprising in HK + Institutional Imperative and Differentiating Between the Tech Innovators, the Imitators and the Swarming Incompetents in Asia

One of the stocks – 21Vianet – in the article was mentioned by Straits Times last week in the Cover Page Story(!)… the accounting looks funny..

PS: Here are some links to the Straits Times/Forbes article.

Have a good week ahead and all the best to your Test 1 next week.

Warm regards,

KB

Managing Editor

The Moat Report Asia

www.moatreport.com

SMU: http://accountancy.smu.edu.sg/faculty/profile/108141/Kee%20Koon%20Boon

“In business, I look for economic castles protected by unbreachable ‘moats’.”

– Warren Buffett

The Moat Report Asia is a research service focused exclusively on competitively advantaged, attractively priced public companies in Asia. Together with our European partners BeyondProxy andThe Manual of Ideas, the idea-oriented acclaimed monthly research publication for institutional and private investors, we scour Asia to produce The Moat Report Asia, a monthly in-depth presentation report highlighting an undervalued wide-moat business in Asia with an innovative and resilient business model to compound value in uncertain times. Our Members from North America, the Nordic, Europe, the Oceania and Asia include professional value investors with over $20 billion in asset under management in equities, secretive global hedge fund giants, and savvy private individual investors who are lifelong learners in the art of value investing.

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Our latest monthly issue for the month of August investigates an Asian-listed company who’s the leading ecommerce group in its home country with the complete platform coverage in the Amazon-type of B2C ecommerce of selling directly to end consumers (Sales/Net Profit: 90%/78%), Rakuten-type of B2B2C platform (Sales/Net Profit: 4%/12%) to support the online SME merchants who in turn sell to the end consumers, and the eBay-type of C2C auction site (Sales/Net Profit: 2%/21%) where individuals buy and sell to one another. This “Amazon-Alibaba” is highly profitable with recurring free cashflow (FCF yield 4.6-5% compounding at 25% in the next 3-5 years) by pioneering the world’s-first 24-hour delivery promise and guarantee when world-class logistics experts said it cannot be done. In emerging markets and Asia where logistics costs is 15-20% of GDP, most ecommerce companies fail to scale up due to lack of fulfillment capabilities and inventory risk became the killing blow as they pursue growth without the intangible know-how. The company designs and builds its own warehouses to provide fast and efficient delivery with 99.68% on-time rate and also complete backend services to suppliers, widening the gap between itself and peers. With its superior infrastructure, the company is able to provide consumers a one-stop shopping experience with all goods purchased from different vendors packaged into a single box and delivered to the client’s door. The company has consignment agreements with suppliers which allow it to have control over inventory management but carry no liability of inventory on its balance sheet, in other words, there is minimal inventory risk for the company to scale up sustainably and without the usual accounting risks that plagued the ecommerce companies.

With (1) a superior ROE of 23.6% due to its wide-moat business model in 24-hour delivery system, (2) negative cash conversion cycle (-29 days) in its unique warehouse system with minimal inventory risk, (3) a sustained 25-30% recurring earnings and cashflow growth per annum in the next 5 years, especially a long run-way in disrupting traditional retailers, and (4) potential exponential growth in its option value in the third-party electronic payment business, the company can scale up multiple times. Short-term downside risk is protected by its healthy $128m net-cash balance sheet (15% of MV) and proven management execution in prudent capex expansion to support sustainable quality earnings growth. Its terminal value and long-term downside risk will be protected by giants Alibaba, Rakuten, eBay, Amazon who wish to swallow it up to possess its valuable trust and brand equity support it enjoys and its wide-moat business model in 24-hour delivery system. The company is one of the few Asian ecommerce companies with good governance and low accounting risks with its net-value revenue recognition method and it deserves a valuation premium. Upcoming deregulation in third-party electronic payment with the passing of the law in Sep 2014 will result in various government restrictions to be removed, paving the way for the company to introduce stored-value payments, O2O payment, P2P payment (money transfer without transactions), multiple currencies’ payments, big data analysis, payment services for customers outside the group to boost transaction volume and scale up its existing proprietary PayPal/AliPay business. Led by the inspiring and highly-determined founder and Chairman who established and listed the company in 1998 and 2003 respectively, the company has overcome the multiple obstacles to ecommerce transactions in its home market. The founder described the obstacles to ecommerce transactions as ‘friction’, and that he “resolve to take on the Life’s Task to reduce this ‘friction’”.

Our past monthly issues examine:

• An Asian-listed company who’s the global #1 and #2 maker of two types of patient monitoring devices for both clinical- and home-use. Founded in 1981 and listed in 2001, the company’s reliable manufacturing technology platform for over 30 years has enabled it to build a global durable franchise in the niche patient monitoring device market that has stable resilient growth and yet is experiencing potential disruptions led by its new innovation. A secret to its success is its in-house capabilities to combine Swiss design, high-precision electronics and sensors components with clinical healthcare to produce world-class products with cost competitiveness. The firm has competitive technology and patents especially its core competence of having an algorithm to allow fast reading/filtering of signals and outputting the accurate results in a short period of time. Thecompany has the potential to consolidate the market further. The company is also a sticky ODM partner to reputable companies including Wal-Mart, Costco, CVS and it has adiversified customer base with none of the customers accounting for more than 10% of its sales. The company demonstrated that it has bargaining power over its powerful customers with the ability to build its own brand since 1998 (62% of overall sales). 91% of its sales are to developed markets in US and Europe. The company is trading at EV/EBIT 9.7x and EV/EBITDA 8.8x and has an attractive dividend yield at 5.6% and a strong balance sheet with net cash as percentage of market value and book equity at 23% and 47% respectively. The firm has also undertaken the unusual capital management program to reduce 10% of its shares outstanding in Sep 2012 to boost capital efficiency by utilizing the comfortable net cash position. The proactive shareholder-friendly stance backed by its strong net cash position should limit any downside in share price. The company’s terminal value and downside risk will be protected by giants such as J&J, Bayer, Abbott etc who wish to swallow it up to possess its valuable manufacturing technology platform and worldwide patents in algorithm-technology. The company’s worldwide patents in algorithm-technology has been commercialized into an innovative product series that is at the heart of its total solution service business model. This valuable intangible asset is not factored into long-term valuation. The innovative product with the algorithm measurement technology are not merely additional features; it “forces” the clinical community to adopt them as the standard, which in turn helps drive home-use penetration as patients seek a consistent and integrated healthcare experience. It transforms the product into a unique strategy that incorporates software development to create value-added services for health monitoring and collaborating with hospitals and governments on tele-healthcare projects. As a result of its wide-moat, the company has a far superior ROE at 20.9% that is nearly double that of its key giant conglomerate rival. When we compare EV/EBIT relative to ROE and ROA, the company is cheaper by as much as 120-150% when compared to its key giant conglomerate rival. The stock price of the company is down nearly 20% from its recent high in end March 2014 on profit-taking by short-term investors. Share price is back to May 2013 level, representing an attractive opportunity to take position in this long-term durable franchise. The stable long-term shareholdings and patient capital by the founder and the management team who together own around 48% of the equity has enabled the firm to adopt a very long-term approach to building its business and cultivating new growth areas. While he may sometimes be slightly over-optimistic and thinking too far ahead with his long-term opinions, this  idealistic engineer-visionary-philosopher has done a fantastic job in continuously defying the odds of many skeptics by growing the company from a small startup into one of the world’s leading patient monitoring equipment company. He is the rare Asian entrepreneur who was persistent in building his own brand despite the threat of offending his ODM customers. He was also early in cultivating and coordinating a global network with high-tech component, R&D and manufacturing in his home country, manufacturing, assembly and packaging in Shenzhen, China and medical R&D and clinical testing center in Europe, including making the difficult decision to establish a direct marketing sales force in Europe and North America given the high cost. Unlike most Asian business owners whose interest and focus in the core business starts to wane due to complacency from growing personal wealth and the inability to scale the core business, the founder is genuinely passionate in the company’s ability to add value to the patients and society. The firm can effectively run without the founder with the long-term corporate culture and management system in place, yet he can inject great value as the steward in new innovations; we believe that this combination is rare for an Asian company and deserves a valuation premium.

• The world’s #1 ODM (Original Design Manufacturer) and global #5 manufacturer of a consumer healthcare device product that is used frequently, even daily, thus providing the foundation for stable recurring cashflow. This company is also a hidden champion in a niche product segment (50-55% of group’s sales) that has become a high-growth fashion product currently accounting for less than 10% of the overall industry. The company is able to mass-manufacture this niche product, but not the giants, because of its unique process IP in flexible manufacturing system and know-how to handle large-scale complex orders. The manufacture of this product itself is difficult to replicate and requires FDA/CE licenses because of its medical device nature and the entry barrier is not capital but the know-how and R&D expertise. In particular, the manufacturing integrates different fields of science including polymer chemistry, physics, optics, engineering, materials control, process control, microbiology, and, injection molding. The firm has also developed a proprietary system of tracking the manufacturing process of different sets of product so that if a quality issue arose, when and where the problem set of products was being produced could be swiftly identified, thus diminishing the scale and cost of product recall. This system has helped the firm win the long-term trust of its ODM customers to place stable large orders. The Big Four giants do not have such a system and have to incur substantial losses from product recalls. The company also possess its own brand which has many loyal followers and support in its home market where it enjoys a 30% market share and contributes to 25% of group’s saleswhile sticky ODM customers account for 75% of group’s sales, mainly from the Japan market. As a result of its wide-moat advantages, the firm enjoys a consistently high ROE of 41%, double or triple that of the giants. From FY07 onwards, even during the depths of the Global Financial Crisis in 2007/09, the firm has not raised equity. Since listing in Mar 2004, the company has only done one rights issue in May 2005. Also, it is able to sustain a strong stable cash dividend payout (>70% with 3% yield) with its healthy net-cash balance sheet (net cash $30m; net cash-to-equity ratio 23%) and proven management execution in prudent capex expansion to support sustainable quality earnings growth. M&A deals in the healthcare and medical device sector has been growing due to their strong defensive nature and giants seeking growth to overcome their own patent cliff. The firm will always be an attractive takeover target by giants who wish to swallow it up to possess its valuable flexible manufacturing system and know-how to fill their own missing competency gap and hence will enjoy long-term downside protection in its terminal value. In the battle between “ODM vs Brand”, we find the story of the company to be quite similar to that of TSMC (2330 TT, MV $103bn), now the largest ODM foundry in the world. “Skate to where the puck is going to be, not where it has been,” as hockey legend Wayne Gretzky advised. In our view, the profit and valuation premium in the value chain will start to skate to the “Inno-facturers” who are the hidden ODM innovators (the brand behind brands) consolidating the industry, such as TSMC and this company. While its valuation is not cheap with EV/EBIT (FY13) at 20.6x, when we compare EV/EBIT relative to ROE, the company is relatively cheap, by as much as 130-220% when compared to giants and other comparables. When we compare EV/EBITDA relative to ROE, the valuation gap is 90-160%. This long-term valuation gap implies that the company, with its far superior and sustainable ROE, could potentially double to $2.4bn, as it continues to consolidate its niche product segment and enter into a new product cycle of an innovative product whose patents are expiring in 2014/15 (US/worldwide) to make ASP/margin improvements in sustaining quality profits and cashflow. Its share price has dropped 18% from its recent high and underperformed the index by 26% in the last six months. This will present a buying opportunity for long-term value investors who can penetrate beyond conventional valuation metrics because of a deep understanding of its business model and underlying source of its wide-moat advantages. In Asia, many firms break apart or become value traps due to shareholder conflict, envy and differences in opinion on the business direction of the company. The stable long-term corporate culture infused by the late founder, who established the company in 1986 with the current executive chairman and 2 other key shareholders, to combine the energy and ideas of everyone to work hard to keep the business running forever is underappreciated.

• The Home Depot of Asiawhich has the largest market share in its home country and now seeks to expand regionally. It is one of the few home improvement retailers in the world which is able to achieve a structural negative cash conversion cycle (CCC) at -39 days for resilient, recurring and sustainable operating cashflow to enable the expansion of its store network while keeping a healthy balance sheet. It is hard to achieve negative cash conversion cycle (CCC) as a home retailer as compared to a supermarket retailer as the product nature is more durable. Even Home Depot, Lowe’s and Bed Bath & Beyond (BBBY) are not able to achieve a negative CCC. Led by the capable owner-operators since 1995, the company is a pioneer in proactively creating awareness and demand in the minds of consumers that upgrading your home can be fun and in incremental affordable steps. Its creative branding has resulted in the firm to become the “first on customers’ mind”, or what Charlie Munger elucidated as the “psychological wide-moat” advantage. 80% of sales are generated customers looking for home improvement and renovation ideas and solutions.  Growth is supported by the management’s proven ability to identify and cater to dynamic changes in customer preferences. The firm’s comprehensive pre and aftersales service creates brand loyalty and sustains long-term sales. The merchandizing management is tailored to the peculiarities of customer preferences in each area to drive same store sales growth with creative customization by store, location, season and events. Its key strategy to expand its profit margin is to increase its higher-margin house brands and product-mix management. Its EBITDA/sqm of $400/sqm was higher than Home Depot until Home Depot experienced a rebound last year to $500/sqm. The firm’s resilient sales are supported by its unrivalled network of diverse locations throughout the country. Its bold vision and successful “Blue Ocean” execution in the highly fragmented second-tier markets has created a powerful wide-moat advantage that will last for many years to come. In short, the management have proven their ability to execute in difficult market and industry conditions especially in the past 5 to 7 years during the 2007/09 global financial crisis with the firm emerging much stronger. The Illinois Institute of Technology engineering graduate and quiet billionaire owner behind the home retailer is one of the few Asian business tycoons who has the thirst to scale up the business in a sustainable way, as opposed to opportunistic ventures, having been largely influenced by his early years experience observing the success of American wide-moat firms. If we can adjust the EV/EBITDA valuation metric to reflect the CCC, the company’s EV/EBITDA of 18.5x will be lower at 10-11x, while Home Depot’s EV/EBITDA 11x will be higher at 13x. Noteworthy is that Home Depot has a negative free cashflow throughout FY1989-2001 (13 consecutive years!) and yet market cap has climbed from $1.5bn to $103bn. Home Depot compounded despite the ugly valuations during the capex ramp-up. This once again highlights that the power of wide-moat is often underappreciated, misunderstood and overlooked. When Home Depot generated $180m in operating cashflow in FY1992, quite similar to this Asian firm now, Home Depot is valued at $5bn (vs $3bn). Store network is expected to double in the next 4-5 years, representing a potential doubling in market value.

• The Northeast Asian-listed companywho is the world’s largest maker of an essential component with applications in apparel, shoes, diapers, car seats etc. All top 20 global athletic shoe brands, including Nike, Adidas, Reebok, Sketchers, UnderArmor are customers and this Asian innovator with R&D capabilities has forged long-term “spec-in” partnerships with them. Its broad product offering is protected by over 110 patents. By locating its Pan-Asian production plant network in China, Taiwan, Vietnam and Indonesia close to its major clients, including sales/customer service centers and warehouses in US and Europe, the firm is better positioned to understand their requirements, deliver fast and meet their needs. While top 10 athletic shoe brands account 40% of its revenue, the firm has a diversified clientele base of over 10,000 customers, giving it resilience and growth with both the established and emerging brands as clients. The company is trading at PE14e 12x, EV/EBITDA 7.1x and EV/EBIT 10.6x with a dividend yield of 3.9%.Interestingly, its EBITDA margin is double that of Adidas and its 8.7% net margin is higher than Adidas’ 5.4%, though below Nike’s 9.8%. Given the tipping point of its Pan-Asian production network and contributions from its new products and as capex tapers off in the next few years, free cashflow could be around $50-60m and applying a P/FCF of 15x would yield a market value of $750-900m,, representing a potential upside of 100-150%. Thus, the firm offers a similar quality growth trajectory to Nike/Adidas with its unique knowledge-based business model and yet trades at a more attractive valuation and higher dividend yield as downside protection.

• The Middleby of Asia commanding a dominant market share of over 80% in hypermarkets, 50% in chain outlets, 30% in 4- to 5-star hotels in China and an overall 30% in its home market. Yet, no single customer accounts for more than 5% of its revenue. Just to recall for value investors, NYSE-listed Middleby, with its sleepy and boring business, has compounded 100-fold from around $50m to $5.7bn since its tipping point in 1999. The founders of this Asian family business demonstrated clear dedication in building up the company with its wide-moat business model backed by a strong and unique distribution/marketing network in finding, winning and binding new customers to build massive brand equity and long-lasting relationships with clients over time. Their devotion to its core product for nearly 20 years results in maximum problem-solving skills, innovative strength and product leadership and hence, to ever greater customer benefit that will protect the company to consolidate the fragmented market and provide ample opportunities to continue its profitable growth. The company is currently trading at PE13e 15.8x and an undemanding EV/EBIT 10.1x and EV/EBITDA 9.5xand its growth potential based on its unique business model is not priced in. There is a structural re-rerating of niche business models with (1) diversified client base, (2) steady revenue streams, (3) lean capex requirements that creates ample free cashflow and defensive growth. Based on PE, P/CFO and EV/EBIT, the company is trading at a 40-50% discount to the foreign listed comparables despite more efficient use of assets in generating profits and cashflow. It has an attractive 7% earnings yield growing at 20% over the next 3-5 years and a 3.8% dividend yield that is supported by its strong cashflow generation ability, steady revenue stream and lean capex requirements to limit downside risks in valuation. Based on the growth plans to penetrate new product and customer segments; build its third plant in India in addition to the ones in its home market and in China; and potential bolt-on acquisition opportunities with its healthy balance sheet in net-cash position, it has the potential to double its operating cashflow in the next 3-5 years and market value could double, representing an upside potential of 100-140%.

The Moat Report Asia Members’ Forum has been getting penetrating quality dialogues from our subscribers. Questions range from:

• The nuances of internal dealings in Asia, including the case discussion of the recent deal in which HK billionaire’s Lee Shau-kee Henderson Landacquiring Towngas or Hong Kong & China Gas (3 HK) from his family holdings, seemingly déjà vu from the early Oct 2007 transaction when the market peak.
• The case of F&N Singaporespinning out its property unit FCL Trust and getting “free” special dividend-in-specie and the potential risk in asset swap restructuring to deleverage the hidden debt in the entire Group balance sheet.
• The dilemma of whether to invest in a Southeast Asian-listed company and hidden champion with a domestic market share of 60% due to family squabbles and a legal suit over the company’s ownership.
• Discussion of the wise and thoughtful 107-year-old Irving Kahn’s investment into a US-listed but Hong Kong-based electronics company with development property project in Shenzhen’s Qianhai zone and the possible corporate governance risks that could be underestimated or overlooked, as well as their history of listing some assets in HK in 2004.. This is also a case study of “buy one get one free” in John’s highly-acclaimed book The Manual of Ideasin which the “free” property is lumped together with the (eroding) core business to make the combined entity look cheap and undervalued. What are the potential areas that value investors need to watch out for when adapting the SOTP (sum-of-the-parts) valuation method in Asia?
• And many more intriguing questions.

Do find out more in how you can benefit from authentic and candid on-the-ground insights that sell-side analysts and brokers, with their inherent conflict-of-interests, inevitable focus on conventional stock coverage and different clientele priorities, are unwilling or unable to share. Think of this as pressing the Bloomberg “Help Help” button to navigate the Asian capital jungle. Institutional subscribers also get access to the Bamboo Innovator Index of 200+ companies and Watchlist of 500+ companies in Asia and the Database has eliminated companies with a higher probability of accounting frauds and  misgovernance as well as the alluring value traps.

Our 8^th run of the series of workshop From the Fund Management Jungles: Value Investing Exposed and Explored – (Part 1) Moat Analysis, (Part 2) Tipping Point Analysis and (Part 3) Detecting Accounting Fraud – on 14 June 2014 has been well-received with serious value investors, professionals, and serious lifelong learners attending, with some who flew in from Jakarta and KL!..

Our 9th workshop will be on Detecting Accounting Fraud Ahead of the Curve sometime later in the year.

Thank you for your support all this while!

Thank you so much for reading as always.

Warm regards,

KB Kee

Managing Editor

The Moat Report Asia

Singapore

Mobile: +65 9695 1860

A Service of BeyondProxy LLC

1608 S. Ashland Avenue #27878

Chicago, Illinois 60608-2013

Other offices: London, Singapore, Zurich

P.S.1 Here is a little more about my background:

KB Kee has been rooted in the principles of value investing for over a decade as an analyst in Asian capital markets. He was head of research and fund manager at a Singapore-based value investment firm. As a member of the investment committee, he helped the firm’s Asia-focused equity funds significantly outperform the benchmark index. He was previously the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company.

He holds a Masters in Finance and degrees in Accountancy and Business Management, summa cum laude, from Singapore Management University (SMU) and had also published articles on governance and investing in the media, as well as published an empirical research paper Why ‘Democracy’ and ‘Drifter’ Firms Can Have Abnormal Returns: The Joint Importance of Corporate Governance and Abnormal Accruals in Separating Winners from Losers in the Special Issue of Istanbul Stock Exchange 25^th Year Anniversary Best Paper Competition, Boğaziçi Journal, Review of Social, Economic and Administrative Studies, Vol. 25(1): 3-55. KB has also presented his thought leadership as a keynote speaker in global investing conferences. KB has trained CEOs, entrepreneurs, CFOs, management executives in business strategy, value investing, macroeconomic, industry trends, and detecting accounting frauds in Singapore, HK and China, and had taught accounting at the SMU where he is currently an adjunct lecturer.

P.S.2  Why do I care so much about doing The Moat Report Asia for you?

My personal motivation in embarking on this lifelong journey has been driven by disappointment from observing up close and personal the hard-earned assets of many investors, including friends and their families, burnt badly by the popular mantra: “Ride the Asian Growth Story!” I witnessed firsthand the emotional upheavals that they go through when they invest their hard-earned money – and their family’s – in these “Ride The Asian Growth Story” stocks either by themselves or through money managers, and these stocks turned out to be the subject of some exciting “theme” but which are inherently sick and prey to economic vicissitudes. They may seem to grow faster initially but the sustainable harvest of their returns is far too uncertain to be the focus of a wise program in investment. Worse still, the companies turned out to be involved in accounting frauds. Their financial numbers were “propped up” artificially to lure in funds from investors and the studiously-assessed asset value has already been “tunnelled out” or expropriated. And western-based fraud detection tools and techniques have not been adapted to the Asian context to avoid these traps.

After a decade-plus journey in the Asian capital jungles, it has been somewhat disheartening as I observe many fraud perpetrators go away scot-free and live a life of super luxury on minority investors’ hard-earned money. And these perpetrators make tempting offers to various parties in the financial community to go along with their schemes. When investors have knowledge in their hands, we have a choice to stay away from these people and away from temptations and do the things that we think are right. With knowledge, we have a choice to invest in the hardworking Asian entrepreneurs and capital allocators who are serious in building a wide-moat business.

The Moat Report Asia
A Service of BeyondProxy LLC
1608 S. Ashland Avenue #27878
Chicago, Illinois 60608-2013

Other offices: London, Singapore, Zurich

• The weekly insight is a teaser into the opportunities – and pitfalls! – in the Asian capital jungles.
• Get The Moat Report Asia– a monthly in-depth presentation report of around 30-40 pages covering the business model of the company, why it has a wide moat and why the moat may continue to widen, a special section on “Inside the Leader’s Mind” to understand their thinking process in building up the business, the context – why now (certain corporate or industry events or groundbreaking news), valuations (why it can compound 2-3x in the next 5 years), potential risks and how it is part of the systematic process in the Bamboo Innovator Index of 200+ companies out of 15,000+ in the Asia ex-Japan universe.
• Our paid Members from North America, Europe, the Oceania and Asia include professional value investors with over $20 billion in asset under management in equities, some of the world’s biggest secretive global hedge fund giants, and savvy private individual investors who are lifelong learners in the art of value investing.

What can the Apple Watch do that the iPhone can’t?

The most “wow” that Tim Cook elicited in his launch of the Apple Watch last Tuesday was a Starwood app that will let you bypass the check-in queues and check into a hotel room by just waving your Apple Watch to open the door of the properties which include the Westin, Sheraton, W and so on.

The answer to the elusive “killer-app” for smartwatches – the feature that will make them indispensable in people’s lives – will unlock the estimated value of the $93-billion wearable devices market, of which smartwatches are believed to account for two-thirds of the value. There is, however, growing disillusionment on the prospect for wearables: Nike has already abandoned its initially-promising Fuelband unit which ran up $60m in sales in 2013 andeBay has been flooded with Samsung Galaxy Gear smartwatches which clocked in $240m in sales last year.

Instead of thinking about Apple Watch as a stand-alone product that Swiss watchmakers scoffed at, imagine if the Apple Watch can work together with the iPhone to do a two-factor authentication for payments to replace your wallet, including new things that the two connected devices can do together. As Apple assumes a more central role in the financial universe with its Apple Pay service that uses the near-field communication (NFC) to exchange information wirelessly between devices, the 50-year-old antiquated credit card system might be transformed and new types of transactions previously done with cash and other payment methods might be processed, creating a new wave of demand. “It’s all about the wallet. Our vision is to replace this,” Tim Cook warmed up the crowd. Visa,MasterCard and American Express – who account for 83% of all credit card volumes in US – are all signed up for the Apple Pay launch, including a significant number of merchants including Starbucks, Disney, Whole Foods,McDonald’s.

The Apple Watch is the company’s first major advance into a new product category since the iPad in 2010. Apple was not exclusively about the discovery and commercialisation of the innovative new products from iPod (unveiled in October 2001), iPhone (June 2007) to the latest iPad (April 2010). Its wide-moat success comes from wrapping the new products around the “emptiness” of deep know-how to provide game-changing portable digital lifestyle experience to the consumer by combining hardware, software, service, and an ecosystem of partners, making downloading of digital music, video, games and apps via iTunes Store (since April 2003) easy and convenient. Imitators of the hardware all burn down because they fail to appreciate and replicate the amount of deep thoughts, details and executions that go into integrating the device into the lives of the consumer.

The potential winners in the vast Apple supply chain in Asia will also be in focus. However, there are cautionary tales for value investors. Currently, these Asian suppliers include main assembler Quanta Computer (2382 TT, MV $10.3bn), packaging and testing company ASE (2311 TT, MV $9.5bn), power control IC designer Richtek (6286 TT, MV $770m), IC substrate company Kinsus (3189 TT, MV $1.7bn), flexible printed circuit board Career Tech (6153 TT, MV $439m), electro-acoustic components makers Merry (2439 TT, MV $1bn), AAC (2018 HK, MV $7.5bn) andGoerTek (002241 CH, MV $6.9bn), GPS system RoyalTek (3306 TT, MV $75m), quartz crystal and clock control modules TXC (3042 TT, MV $427m), curved flexible AMOLED display screen from LG Display (034220 KS, MV $12bn).

Should you invest in Apple or attempt to pick its winning Asian suppliers, especially when Apple is now the world’s most valuable company with a dizzying $608-billion market cap? A cautionary tale comes from TPK Holding (3673 TT, $2.1bn), the world’s largest touch panel vendor, which generates around 41% of its revenue from Apple. TPK was an early beneficiary of the iPhone, providing…

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TPK Holding (3673 TT) Vs Apple (AAPL US) – Stock Price Performance, 2010-2014

Apple Watch invoked an interesting twist to the fabled tale of how cheap, accurate quartz watches from Japan’s Casio and Seiko in the 1970-80s put many traditional mechanical Swiss watchmakers into bankruptcy. Within a decade of inventing the first quartz watch, the Swiss saw their export volume decrease from 45% to 10% of watches produced globally. By 1983, two-thirds of all watch industry jobs in Switzerland had vanished and over half of all watchmaking companies in Switzerland had gone bankrupt. Swatch Group’s Nicholas Hayek and LVMH watch president Jean-Claude Biver repositioned mechanical watches as luxury and self-identity pieces and the Swiss watch industry no longer competes on the same dimensions as quartz watches.

Apple Watch is a new twist as quartz crystals are key components in frequency generation and control devices for signal timing in smartphones and smartwatches. If the Qualcomm chip is the smartphone’s heart, then the quartz crystal component would be the delivery system, which supplies blood (digital signals) to every part of the body (product). The unassuming quartz crystal serves as the “pulse” of the digital products, propelling all personal computers, digital cameras and mobile phones. The digitization of auto electronics has increased the demand for quartz crystal components from 4 per car to over 40. For mobile phones, that figure has increased from 1-2 per phone to 4-5 per phone, and quartz crystal components are becoming ever smaller and more intricate.

Of the 700m smartphones globally, one of the five uses the quartz crystals produced by Taiwan’s TXC (3042 TT, MV $427m), who overtook Japan’s KDS in April 2013 to become the third largest quartz crystal component maker in the world, only behind Seiko Epson (6724 JP, MV $10.1bn) and NDK (Nihon Dempa Kogyo) (6779 JP, MV $185m). TXC also accounts for 75% of the quartz crystal components of Apple’s mobile devices and its customers also include all the top brands such as Samsung, HTC, Huawei, ZTE etc. TXC currently has 3 production plants in Taoyuan, China’s Ningbo and Chongqing. Its 200+ automated production lines churn out 260m+ monthly quartz crystals. TXC expanded its R&D team six times to 400+ engineers in 10 years, accounting for 20% of the workforce at its Taoyuan factory. Mobile communications remain the largest contributor to TXC at 35% of revenue. New growth applications include motion sensors and bio sensors. Interestingly, since iPhone was launched in June 2007, Apple is up nearly 6-fold while TXC is flat. TXC generates $31m in profits from $316m in sales last year with a ROE of 11.2% and ROA of 7.2%. TXC trades at around PE 11.7x, P/Book 1.6x, EV/EBIT 14.1x, EV/EBITDA 7.3x and a dividend yield of 5.3%.

For a long time, the Japanese dominated with 80% of the global market for quartz crystal components. How did two brothers – Paul Lin Jin-biao and Peter Lin Wan-xin from a Taiwanese farming family break the Japanese monopoly to make TXC third in the world?

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Warm regards,

KB

Managing Editor

The Moat Report Asia

www.moatreport.com

SMU: http://accountancy.smu.edu.sg/faculty/profile/108141/Kee%20Koon%20Boon

To read the exclusive article in full to find out more about the story of the implications of Apple Watch on the Asian supply chain and the story of Taiwan’s TXC, please visit:

• Apple Watch and the Digital Pulse from Asia, Sep 15, 2014 (Moat Report Asia, BeyondProxy)

The Moat Report Asia is a research service focused exclusively on competitively advantaged, attractively priced public companies in Asia. Together with our European partners BeyondProxy and The Manual of Ideas, the idea-oriented acclaimed monthly research publication for institutional and private investors, we scour Asia to produceThe Moat Report Asia, a monthly in-depth presentation report highlighting an undervalued wide-moat business in Asia with an innovative and resilient business model to compound value in uncertain times. Our Members from North America, the Nordic, Europe, the Oceania and Asia include professional value investors with over $20 billion in asset under management in equities, secretive global hedge fund giants, and savvy private individual investors who are lifelong learners in the art of value investing.

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Our latest monthly issue for the month of August investigates an Asian-listed company who’s the leading ecommerce group in its home country with the complete platform coverage in the Amazon-type of B2C ecommerce of selling directly to end consumers (Sales/Net Profit: 90%/78%), Rakuten-type of B2B2C platform (Sales/Net Profit: 4%/12%) to support the online SME merchants who in turn sell to the end consumers, and the eBay-type of C2C auction site (Sales/Net Profit: 2%/21%) where individuals buy and sell to one another. This “Amazon-Alibaba” is highly profitable with recurring free cashflow (FCF yield 4.6-5% compounding at 25% in the next 3-5 years) bypioneering the world’s-first 24-hour delivery promise and guarantee when world-class logistics experts said it cannot be done. In emerging markets and Asia where logistics costs is 15-20% of GDP, most ecommerce companies fail to scale up due to lack of fulfillment capabilities and inventory risk became the killing blow as they pursue growth without the intangible know-how. The company designs and builds its own warehouses to provide fast and efficient delivery with 99.68% on-time rate and also complete backend services to suppliers, widening the gap between itself and peers. With its superior infrastructure, the company is able to provide consumers a one-stop shopping experience with all goods purchased from different vendors packaged into a single box and delivered to the client’s door. The company has consignment agreements with suppliers which allow it to have control over inventory management but carry no liability of inventory on its balance sheet, in other words, there is minimal inventory riskfor the company to scale up sustainably and without the usual accounting risks that plagued the ecommerce companies.

With (1) a superior ROE of 23.6% due to its wide-moat business model in 24-hour delivery system, (2) negative cash conversion cycle (-29 days) in its unique warehouse system with minimal inventory risk, (3) a sustained 25-30% recurring earnings and cashflow growth per annum in the next 5 years, especially a long run-way in disrupting traditional retailers, and (4) potential exponential growth in its option value in the third-party electronic payment business, the company can scale up multiple times. Short-term downside risk is protected by its healthy$128m net-cash balance sheet (15% of MV) and proven management execution in prudent capex expansion to support sustainable quality earnings growth. Its terminal value and long-term downside risk will be protected by giants Alibaba, Rakuten, eBay, Amazon who wish to swallow it up to possess its valuable trust and brand equity support it enjoys and its wide-moat business model in 24-hour delivery system. The company is one of the few Asian ecommerce companies with good governance and low accounting risks with its net-value revenue recognition method and it deserves a valuation premium. Upcoming deregulation in third-party electronic payment with the passing of the law in Sep 2014 will result in various government restrictions to be removed, paving the way for the company to introduce stored-value payments, O2O payment, P2P payment (money transfer without transactions), multiple currencies’ payments, big data analysis, payment services for customers outside the group to boost transaction volume and scale up its existing proprietary PayPal/AliPay business. Led by the inspiring and highly-determined founder and Chairman who established and listed the company in 1998 and 2003 respectively, the company has overcome the multiple obstacles to ecommerce transactions in its home market. The founder described the obstacles to ecommerce transactions as ‘friction’, and that he “resolve to take on the Life’s Task to reduce this ‘friction’”.

Our past monthly issues examine:

• An Asian-listed company who’s the global #1 and #2 maker of two types of patient monitoring devices for both clinical- and home-use. Founded in 1981 and listed in 2001, the company’s reliable manufacturing technology platform for over 30 years has enabled it to build a global durable franchise in the niche patient monitoring device market that has stable resilient growth and yet is experiencing potential disruptions led by its new innovation. A secret to its success is its in-house capabilities to combine Swiss design, high-precision electronics and sensors components with clinical healthcare to produce world-class products with cost competitiveness. The firm has competitive technology and patents especially its core competence of having an algorithm to allow fast reading/filtering of signals and outputting the accurate results in a short period of time. Thecompany has the potential to consolidate the market further. The company is also a sticky ODM partner to reputable companies including Wal-Mart, Costco, CVS and it has a diversified customer base with none of the customers accounting for more than 10% of its sales. The company demonstrated that it has bargaining power over its powerful customers with the ability to build its own brand since 1998 (62% of overall sales). 91% of its sales are to developed markets in US and Europe. The company is trading at EV/EBIT 9.7x and EV/EBITDA 8.8x and has an attractive dividend yield at 5.6% and a strong balance sheet with net cash as percentage of market value and book equity at 23% and 47% respectively. The firm has also undertaken the unusual capital management program to reduce 10% of its shares outstanding in Sep 2012 to boost capital efficiency by utilizing the comfortable net cash position. The proactive shareholder-friendly stance backed by its strong net cash position should limit any downside in share price. The company’s terminal value and downside risk will be protected by giants such as J&J, Bayer, Abbott etc who wish to swallow it up to possess its valuable manufacturing technology platform and worldwide patents in algorithm-technology. The company’s worldwide patents in algorithm-technology has been commercialized into an innovative product series that is at the heart of its total solution service business model. This valuable intangible asset is not factored into long-term valuation.The innovative product with the algorithm measurement technology are not merely additional features; it “forces” the clinical community to adopt them as the standard, which in turn helps drive home-use penetration as patients seek a consistent and integrated healthcare experience. It transforms the product into a unique strategy that incorporates software development to create value-added services for health monitoring and collaborating with hospitals and governments on tele-healthcare projects. As a result of its wide-moat, the company has a far superior ROE at 20.9% that is nearly double that of its key giant conglomerate rival. When we compare EV/EBIT relative to ROE and ROA, the company is cheaper by as much as 120-150% when compared to its key giant conglomerate rival. The stock price of the company is down nearly 20% from its recent high in end March 2014 on profit-taking by short-term investors. Share price is back to May 2013 level, representing an attractive opportunity to take position in this long-term durable franchise. The stable long-term shareholdings and patient capital by the founder and the management team who together own around 48% of the equity has enabled the firm to adopt a very long-term approach to building its business and cultivating new growth areas. While he may sometimes be slightly over-optimistic and thinking too far ahead with his long-term opinions, this  idealistic engineer-visionary-philosopher has done a fantastic job in continuously defying the odds of many skeptics by growing the company from a small startup into one of the world’s leading patient monitoring equipment company. He is the rare Asian entrepreneur who was persistent in building his own brand despite the threat of offending his ODM customers. He was also early in cultivating and coordinating a global network with high-tech component, R&D and manufacturing in his home country, manufacturing, assembly and packaging in Shenzhen, China and medical R&D and clinical testing center in Europe, including making the difficult decision to establish a direct marketing sales force in Europe and North America given the high cost. Unlike most Asian business owners whose interest and focus in the core business starts to wane due to complacency from growing personal wealth and the inability to scale the core business, the founder is genuinely passionate in the company’s ability to add value to the patients and society. The firm can effectively run without the founder with the long-term corporate culture and management system in place, yet he can inject great value as the steward in new innovations; we believe that this combination is rare for an Asian company and deserves a valuation premium.

• The world’s #1 ODM (Original Design Manufacturer) and global #5 manufacturer of a consumer healthcare device product that is used frequently, even daily, thus providing the foundation for stable recurring cashflow. This company is also a hidden champion in a niche product segment (50-55% of group’s sales) that has become a high-growth fashion product currently accounting for less than 10% of the overall industry. The company is able to mass-manufacture this niche product, but not the giants, because of its unique process IP in flexible manufacturing system and know-how to handle large-scale complex orders. The manufacture of this product itself is difficult to replicate and requires FDA/CE licenses because of its medical device nature and the entry barrier is not capital but the know-how and R&D expertise. In particular, the manufacturing integrates different fields of science including polymer chemistry, physics, optics, engineering, materials control, process control, microbiology, and, injection molding. The firm has also developed a proprietary system of tracking the manufacturing process of different sets of product so that if a quality issue arose, when and where the problem set of products was being produced could be swiftly identified, thus diminishing the scale and cost of product recall. This system has helped the firm win the long-term trust of its ODM customers to place stable large orders. The Big Four giants do not have such a system and have to incur substantial losses from product recalls. The company also possess its own brand which has many loyal followers and support in its home market where it enjoys a 30% market share and contributes to 25% of group’s saleswhile sticky ODM customers account for 75% of group’s sales, mainly from the Japan market. As a result of its wide-moat advantages, the firm enjoys a consistently high ROE of 41%, double or triple that of the giants. From FY07 onwards, even during the depths of the Global Financial Crisis in 2007/09, the firm has not raised equity. Since listing in Mar 2004, the company has only done one rights issue in May 2005. Also, it is able to sustain a strong stable cash dividend payout (>70% with 3% yield) with its healthy net-cash balance sheet (net cash $30m; net cash-to-equity ratio 23%) and proven management execution in prudent capex expansion to support sustainable quality earnings growth. M&A deals in the healthcare and medical device sector has been growing due to their strong defensive nature and giants seeking growth to overcome their own patent cliff. The firm will always be an attractive takeover target by giants who wish to swallow it up to possess its valuable flexible manufacturing system and know-how to fill their own missing competency gap and hence will enjoy long-term downside protection in its terminal value. In the battle between “ODM vs Brand”, we find the story of the company to be quite similar to that of TSMC (2330 TT, MV $103bn), now the largest ODM foundry in the world. “Skate to where the puck is going to be, not where it has been,” as hockey legend Wayne Gretzky advised. In our view, the profit and valuation premium in the value chain will start to skate to the “Inno-facturers” who are the hidden ODM innovators (the brand behind brands) consolidating the industry, such as TSMC and this company. While its valuation is not cheap with EV/EBIT (FY13) at 20.6x, when we compare EV/EBIT relative to ROE, the company is relatively cheap, by as much as 130-220% when compared to giants and other comparables. When we compare EV/EBITDA relative to ROE, the valuation gap is 90-160%. This long-term valuation gap implies that the company, with its far superior and sustainable ROE, could potentially double to $2.4bn, as it continues to consolidate its niche product segment and enter into a new product cycle of an innovative product whose patents are expiring in 2014/15 (US/worldwide) to make ASP/margin improvements in sustaining quality profits and cashflow. Its share price has dropped 18% from its recent high and underperformed the index by 26% in the last six months. This will present a buying opportunity for long-term value investors who can penetrate beyond conventional valuation metrics because of a deep understanding of its business model and underlying source of its wide-moat advantages. In Asia, many firms break apart or become value traps due to shareholder conflict, envy and differences in opinion on the business direction of the company. The stable long-term corporate culture infused by the late founder, who established the company in 1986 with the current executive chairman and 2 other key shareholders, to combine the energy and ideas of everyone to work hard to keep the business running forever is underappreciated.

• The Home Depot of Asiawhich has the largest market share in its home country and now seeks to expand regionally. It is one of the few home improvement retailers in the world which is able to achieve a structural negative cash conversion cycle (CCC) at -39 days for resilient, recurring and sustainable operating cashflow to enable the expansion of its store network while keeping a healthy balance sheet. It is hard to achieve negative cash conversion cycle (CCC) as a home retailer as compared to a supermarket retailer as the product nature is more durable. Even Home Depot, Lowe’s and Bed Bath & Beyond (BBBY) are not able to achieve a negative CCC. Led by the capable owner-operators since 1995, the company is a pioneer in proactively creating awareness and demand in the minds of consumers that upgrading your home can be fun and in incremental affordable steps. Its creative branding has resulted in the firm to become the “first on customers’ mind”, or what Charlie Munger elucidated as the “psychological wide-moat” advantage. 80% of sales are generated customers looking for home improvement and renovation ideas and solutions.  Growth is supported by the management’s proven ability to identify and cater to dynamic changes in customer preferences. The firm’s comprehensive pre and aftersales service creates brand loyalty and sustains long-term sales. The merchandizing management is tailored to the peculiarities of customer preferences in each area to drive same store sales growth with creative customization by store, location, season and events. Its key strategy to expand its profit margin is to increase its higher-margin house brands and product-mix management. Its EBITDA/sqm of $400/sqm was higher than Home Depot until Home Depot experienced a rebound last year to $500/sqm. The firm’s resilient sales are supported by its unrivalled network of diverse locations throughout the country. Its bold vision and successful “Blue Ocean” execution in the highly fragmented second-tier markets has created a powerful wide-moat advantage that will last for many years to come. In short, the management have proven their ability to execute in difficult market and industry conditions especially in the past 5 to 7 years during the 2007/09 global financial crisis with the firm emerging much stronger. The Illinois Institute of Technology engineering graduate and quiet billionaire owner behind the home retailer is one of the few Asian business tycoons who has the thirst to scale up the business in a sustainable way, as opposed to opportunistic ventures, having been largely influenced by his early years experience observing the success of American wide-moat firms. If we can adjust the EV/EBITDA valuation metric to reflect the CCC, the company’s EV/EBITDA of 18.5x will be lower at 10-11x, while Home Depot’s EV/EBITDA 11x will be higher at 13x. Noteworthy is that Home Depot has a negative free cashflow throughout FY1989-2001 (13 consecutive years!) and yet market cap has climbed from $1.5bn to $103bn. Home Depot compounded despite the ugly valuations during the capex ramp-up. This once again highlights that the power of wide-moat is often underappreciated, misunderstood and overlooked. When Home Depot generated $180m in operating cashflow in FY1992, quite similar to this Asian firm now, Home Depot is valued at $5bn (vs $3bn). Store network is expected to double in the next 4-5 years, representing a potential doubling in market value.

• The Northeast Asian-listed companywho is the world’s largest maker of an essential component with applications in apparel, shoes, diapers, car seats etc. All top 20 global athletic shoe brands, including Nike, Adidas, Reebok, Sketchers, UnderArmor are customers and this Asian innovator with R&D capabilities has forged long-term “spec-in” partnerships with them. Its broad product offering is protected by over 110 patents. By locating its Pan-Asian production plant network in China, Taiwan, Vietnam and Indonesia close to its major clients, including sales/customer service centers and warehouses in US and Europe, the firm is better positioned to understand their requirements, deliver fast and meet their needs. While top 10 athletic shoe brands account 40% of its revenue, the firm has a diversified clientele base of over 10,000 customers, giving it resilience and growth with both the established and emerging brands as clients. The company is trading at PE14e 12x, EV/EBITDA 7.1x and EV/EBIT 10.6x with a dividend yield of 3.9%. Interestingly, its EBITDA margin is double that of Adidas and its 8.7% net margin is higher than Adidas’ 5.4%, though below Nike’s 9.8%. Given the tipping point of its Pan-Asian production network and contributions from its new products and as capex tapers off in the next few years, free cashflow could be around $50-60m and applying a P/FCF of 15x would yield a market value of $750-900m,, representing a potential upside of 100-150%. Thus, the firm offers a similar quality growth trajectory to Nike/Adidas with its unique knowledge-based business model and yet trades at a more attractive valuation and higher dividend yield as downside protection.

• The Middleby of Asia commanding a dominant market share of over 80% in hypermarkets, 50% in chain outlets, 30% in 4- to 5-star hotels in China and an overall 30% in its home market. Yet, no single customer accounts for more than 5% of its revenue. Just to recall for value investors, NYSE-listed Middleby, with its sleepy and boring business, has compounded 100-fold from around $50m to $5.7bn since its tipping point in 1999. The founders of this Asian family business demonstrated clear dedication in building up the company with its wide-moat business model backed by a strong and unique distribution/marketing network in finding, winning and binding new customers to build massive brand equity and long-lasting relationships with clients over time. Their devotion to its core product for nearly 20 years results in maximum problem-solving skills, innovative strength and product leadership and hence, to ever greater customer benefit that will protect the company to consolidate the fragmented market and provide ample opportunities to continue its profitable growth. The company is currently trading at PE13e 15.8x and an undemanding EV/EBIT 10.1x and EV/EBITDA 9.5xand its growth potential based on its unique business model is not priced in. There is a structural re-rerating of niche business models with (1) diversified client base, (2) steady revenue streams, (3) lean capex requirements that creates ample free cashflow and defensive growth. Based on PE, P/CFO and EV/EBIT, the company is trading at a 40-50% discount to the foreign listed comparables despite more efficient use of assets in generating profits and cashflow. It has an attractive 7% earnings yield growing at 20% over the next 3-5 years and a 3.8% dividend yield that is supported by its strong cashflow generation ability, steady revenue stream and lean capex requirements to limit downside risks in valuation. Based on the growth plans to penetrate new product and customer segments; build its third plant in India in addition to the ones in its home market and in China; and potential bolt-on acquisition opportunities with its healthy balance sheet in net-cash position, it has the potential to double its operating cashflow in the next 3-5 years and market value could double, representing an upside potential of 100-140%.

The Moat Report Asia Members’ Forum has been getting penetrating quality dialogues from our subscribers.Questions range from:

• The nuances of internal dealings in Asia, including the case discussion of the recent deal in which HK billionaire’s Lee Shau-kee Henderson Landacquiring Towngas or Hong Kong & China Gas (3 HK) from his family holdings, seemingly déjà vu from the early Oct 2007 transaction when the market peak.
• The case of F&N Singaporespinning out its property unit FCL Trust and getting “free” special dividend-in-specie and the potential risk in asset swap restructuring to deleverage the hidden debt in the entire Group balance sheet.
• The dilemma of whether to invest in a Southeast Asian-listed company and hidden champion with a domestic market share of 60% due to family squabbles and a legal suit over the company’s ownership.
• Discussion of the wise and thoughtful 107-year-old Irving Kahn’s investment into a US-listed but Hong Kong-based electronics company with development property project in Shenzhen’s Qianhai zone and the possible corporate governance risks that could be underestimated or overlooked, as well as their history of listing some assets in HK in 2004.. This is also a case study of “buy one get one free” in John’s highly-acclaimed book The Manual of Ideasin which the “free” property is lumped together with the (eroding) core business to make the combined entity look cheap and undervalued. What are the potential areas that value investors need to watch out for when adapting the SOTP (sum-of-the-parts) valuation method in Asia?
• And many more intriguing questions.

Do find out more in how you can benefit from authentic and candid on-the-ground insights that sell-side analysts and brokers, with their inherent conflict-of-interests, inevitable focus on conventional stock coverage and different clientele priorities, are unwilling or unable to share. Think of this as pressing the Bloomberg “Help Help” button to navigate the Asian capital jungle. Institutional subscribers also get access to the Bamboo Innovator Index of 200+ companies and Watchlist of 500+ companies in Asia and the Database has eliminated companies with a higher probability of accounting frauds and  misgovernance as well as the alluring value traps.

Our 9th workshop will be on Detecting Accounting Fraud Ahead of the Curve sometime later in the year.

Thank you for your support all this while!

Warm regards,

KB Kee

Managing Editor

The Moat Report Asia

Singapore

Mobile: +65 9695 1860

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Other offices: London, Singapore, Zurich

He holds a Masters in Finance and degrees in Accountancy and Business Management, summa cum laude, from Singapore Management University (SMU) and had also published articles on governance and investing in the media, as well as published an empirical research paper Why ‘Democracy’ and ‘Drifter’ Firms Can Have Abnormal Returns: The Joint Importance of Corporate Governance and Abnormal Accruals in Separating Winners from Losers in the Special Issue of Istanbul Stock Exchange 25^th Year Anniversary Best Paper Competition, Boğaziçi Journal, Review of Social, Economic and Administrative Studies, Vol. 25(1): 3-55. KB has also presented his thought leadership as a keynote speaker in global investing conferences. KB has trained CEOs, entrepreneurs, CFOs, management executives in business strategy, value investing, macroeconomic, industry trends, and detecting accounting frauds in Singapore, HK and China, and had taught accounting at the SMU where he is currently an adjunct lecturer.

P.S.2  Why do I care so much about doing The Moat Report Asia for you?

My personal motivation in embarking on this lifelong journey has been driven by disappointment from observing up close and personal the hard-earned assets of many investors, including friends and their families, burnt badly by the popular mantra: “Ride the Asian Growth Story!” I witnessed firsthand the emotional upheavals that they go through when they invest their hard-earned money – and their family’s – in these “Ride The Asian Growth Story” stocks either by themselves or through money managers, and these stocks turned out to be the subject of some exciting “theme” but which are inherently sick and prey to economic vicissitudes. They may seem to grow faster initially but the sustainable harvest of their returns is far too uncertain to be the focus of a wise program in investment. Worse still, the companies turned out to be involved in accounting frauds. Their financial numbers were “propped up” artificially to lure in funds from investors and the studiously-assessed asset value has already been “tunnelled out” or expropriated. And western-based fraud detection tools and techniques have not been adapted to the Asian context to avoid these traps.

After a decade-plus journey in the Asian capital jungles, it has been somewhat disheartening as I observe many fraud perpetrators go away scot-free and live a life of super luxury on minority investors’ hard-earned money. And these perpetrators make tempting offers to various parties in the financial community to go along with their schemes. When investors have knowledge in their hands, we have a choice to stay away from these people and away from temptations and do the things that we think are right. With knowledge, we have a choice to invest in the hardworking Asian entrepreneurs and capital allocators who are serious in building a wide-moat business.